Category Archives: PSST and Macro

Why I Quit Macroeconomics

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We construct a microfounded, dynamic version of the IS-LM-Phillips curve model by adding two elements to the money-in-the-utility-function model of Sidrauski (1967). First, real wealth enters the utility function. The resulting Euler equation describes consumption as a decreasing function of the interest rate in steady state–the IS curve. The demand for real money balances describes consumption as an increasing function of the interest rate in steady state–the LM curve. The intersection of the IS and LM curves defines the aggregate demand (AD) curve. Second, matching frictions in the labor market create unemployment. The aggregate supply (AS) curve describes output sold for a given market tightness. Tightness adjusts to equalize AD and AS curve for any price process. With a rigid price process, this steady-state equilibrium captures Keynesian intuitions. Demand and supply shocks affect tightness, unemployment, consumption, and output. Monetary policy affects aggregate demand and can be used for stabilization. Monetary policy is ineffective in a liquidity trap with zero nominal interest rate. In contrast, with a flexible price process, aggregate demand and monetary policy are irrelevant when the nominal interest rate is positive. In a liquidity trap, monetary policy is useful if it can increase inflation. We discuss equilibrium dynamics under a Phillips curve describing the slow adjustment of prices to their flexible level in the long run.

That is the abstract of a new paper by Pascal Michaillat and Emmanuel Saez. It was while I was in graduate school that this sort of mathematical self-abuse took over the field.

Macro Experiments are not Controlled

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Alex Tabarrok writes,

I happen to agree with Krugman that one test is not decisive. The economy is very complex and we don’t have controlled macro-experiments so lots of things are going on at the same time.

Read the whole thing, especially if you do not know the austerity-test controversy to which Alex is referring. And if you want more, you can read Mark Thoma or Scott Sumner either at EconLog or at MoneyIllusion.

My comments.

1. Don’t throw all your eggs at Paul Krugman. Save some for Mark Zandi, of Macroeconomic Advisers Moody’s, who also forecast dire consequences from the sequester.

2. You don’t have to believe the fiscal austerity was a non-event. You can believe that the economy was about to expand rapidly, and trimming the budget deficit held it back. Although, as Alex points out, telling this story makes it a little harder to say that we were in a liquidity trap/secular stagnation. Anyway, believing that austerity held back a boom is just the mirror image of believing that the stimulus worked, and the only reason that unemployment ended up higher than what was predicted without the stimulus is that the economy was in a deeper hole than we thought. The “deeper hole” theory is now the conventional wisdom among Stan Fischer’s 72 Ph.D advisees and their descendants. That is the beauty of macro. Even something that is defined ahead of time as a “test” is not a controlled experiment.

3. Even if you believe that fiscal austerity was a non-event, you do not have to believe that it was “monetary offset” that made it so. I would suggest that the process of business creation and business destruction did its thing without regard to fiscal and monetary policy.

4. Try to explain why nominal interest rates went up. If austerity matters, then interest rates should come down. If monetary offset works the way it does in old-fashioned textbook models, then interest rates should come down even more.

5. In Scott Sumner’s floofy world where the Fed directly controls NGDP expectations, you would expect nominal interest rates to go up with monetary offset. But I am still trying to come up with even a thought experiment that would refute market monetarism. If 2013 had been a down year, it would just have shown that the Fed failed to maintain NGDP expectations. This is uncharitable, but I think of market monetarism as a theory that can only be confirmed, never rejected.*

Is there anyone I haven’t offended yet?

*To be less uncharitable, let Scott speak for himself.

In my view the now famous Krugman “test” of market monetarism is an indication of the pathetic state of modern macro. We are still in the Stone Age. Future generations will look back on us and shake their heads. What were they thinking? Why didn’t they simply create a NGDP futures market? They’ll look back on us the way modern chemists look back on alchemists. It’s almost like people don’t want to know the truth, they don’t want answers to these questions, as then the mystical power of macroeconomists with their structural models would be exposed as a sham. Remember when the Christian church produced bibles and sermons in a language that only the priesthood could understand? That’s macroeconomics circa 2013.

Brad DeLong’s Questions

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His post is here. I will insert my answers.

Why is housing investment still so far depressed below any definition of normal?

In the U.S., politicians shifted from punishing mortgage lenders for making type II errors (turning down borrowers for loans that might have been repaid) to punishing them for making type I errors (lending to borrowers who might default). In addition, politicians interfered with the foreclosure process. This kept markets from returning to normal, and it further discouraged mortgage lending. What good is the house as collateral for a loan in a world where the government keeps the lender from getting at it?

Why has labor-force participation collapsed so severely?

I believe that this is a trend, amplified by the cycle. Many workers are facing stiff competition from foreign labor and from capital. At the same time, the non-wage component of compensation has gone up, because of health insurance costs. These factors put extreme downward pressure on take-home pay for many workers, and they have responded by dropping out of the labor force.

Why the very large spread between yields on safe nominal assets like Treasuries and yields on riskier assets like equities?

I lean toward a Minsky-Kindleberger answer. During the Great Moderation, confidence in financial intermediation grew. We thought that banks had discovered new ways to manufacture riskless, short-term assets out of risky, long-term investment projects. Then came the financial crisis, and distrust of financial intermediation soared. This made it harder to convince people that you could provide them with riskless, short-term assets backed by risky, long-term projects.

Why didn’t the housing bubble of the mid-2000s produce a high-pressure economy and rising inflation?

It took place in the context of the long-term trend to displace many American workers with capital and with foreign labor. The bubble took us off that trend and the crash put us back on it.

To what extent was the collapse of demand in 2008-2009 the result of the financial crisis and to what extent a simple consequence of the collapse of household wealth?

Great question. It appears that the collapse of household wealth is a sufficient explanation. But if so, then what was the point of TARP and the other bailouts? Of course, putting on my PSST hat, I would reject a phrase like “collapse of demand.” I would say instead that in the wake of the financial crisis, the psychology of existing businesses was that it was a good time to shore up profits by trimming the work force, and the psychology of entrepreneurs was that it was not a good time to try to obtain funding for new businesses.

Why has fiscal policy been so inept and counterproductive in the aftermath of 2008-9?

Not a question that I can answer, given that we disagree on what constitutes inept and counterproductive.

Why hasn’t more been done to clean up housing finance (in America) and banking finance in Europe)?

Politicians care about what happens on their watch. That is why you can count on them to bail out failing financial firms (“Yes, we should worry about moral hazard. But risk some sort of calamity because of a visible financial bankruptcy? Not on my watch.”) That is why you can count on them not to institute major financial reforms. (“Of course, we need a new design here. But do something that could cause short-term disruption to some constituents? Not on my watch.”)

Incidentally, I diagnosed the “not on my watch” bias toward bailouts way back in 2008. Also in September of 2008, I wrote,

Five years from now, we could find ourselves with no exit strategy. My guess is that we’ll be pretty much out of Iraq by then. But it would not surprise me to see Freddie and Fannie still in limbo.

You can read Robert Waldmann’s answers here. Pointer from Mark Thoma.

John Cochrane Interview

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Self-recommending, but I also read it and recommend it. Tyler and Scott have commented on it already.

if we purge the system of run-prone financial contracts, essentially requiring anything risky to be financed by equity, long-term debt, or contracts that allow suspension of payment without forcing the issuer to bankruptcy, then we won’t have runs, which means we won’t have crises. People will still lose money, as they did in the tech stock crash, but they won’t react by running and forcing needless bankruptcies.

This sounds somewhat radical to me. On the one hand, you want to allow some financial intermediation, which I might define as opaque financial institutions that hold risky, long-term assets and issue riskless short-term liabilities. On the other hand, you don’t want bank runs. What I would like to see are deposit-like contracts in which under certain conditions penalties may be imposed for rapid withdrawals. In the middle of a bank run, you can withdraw your money, but you lose, say 10 cents on the dollar. That sort of contract would have saved AIG, for example. When Goldman and the other firms that held credit defaults swaps written by AIG wanted to make withdrawals (termed “collateral calls”) they would have had to think twice about it. I made this suggestion in real time, back in 2008.

The interview has many great sound bites, but my favorites are these:

I think coming up with new theories to justify policies ex post is a particularly dangerous kind of economics.

and

the need for special savings accounts for medicine, retirement, college, and so on is a sign that the overall tax on saving is too high. Why tax saving heavily and then pass this smorgasbord of complex special deals for tax-free saving? If we just stopped taxing saving, a single “savings account” would suffice for all purposes!

Of course, we are getting a lot of the “particularly dangerous kind of economics” in the wake of TARP and the stimulus. I wish that the new theories were being developed to better account for reality, whether or not they serve to justify policy.

Finally,

Time-varying risk premiums say business cycles are about changes in people’s ability and willingness to bear risk. Yet all of macroeconomics still talks about the level of interest rates, not credit spreads, and about the willingness to substitute consumption over time as opposed to the willingness to bear risk. I don’t mean to criticize macro models. Time-varying risk premiums are just technically hard to model. People didn’t really see the need until the financial crisis slapped them in the face.

I think of Minsky as offering a useful theory of time-varying risk premiums, but that is probably not what John has in mind.

I have not given you all of the good material in the interview, by any means.

Puzzling Through Brad DeLong

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He writes,

if we combine the costs of idle workers and capital during the downturn and the harm done to the US economy’s future growth path, the losses reach 3.5-10 years of total output.

That is a higher share of America’s productive capabilities than the Great Depression subtracted

Pointer from Reihan Salam.

Brad goes on to say that conventional macroeconomists know how to fix this, but the evil, heartless plutocrats will not let conventional macroeconomic policy be followed.

I am really struggling to follow his reasoning. I may be wrong, but I think this is how he arrives at the insinuation that what is taking place now is worse than the Great Depression.

1. If you graph U.S. output, the Great Depression shows up as a deviation from trend, but you get back to trend. From a a long-term perspective, there is an adverse shift in the timing of output, but not much in terms of permanently foregone output.

2. Assume that in the future, the U.S. is not going to get back to trend. When you cumulate this shortfall relative to trend, it will be really huge.

If I have this right, then my comments would be:

a) it is the assumption of no return to trend that drives the calculation of such a large loss. The cumulative loss would diminish considerably under an assumption that we do return to trend.

b) if we are not going to return to trend, then it seems to me that Brad has to explain why this does not constitute a supply shock. The conventional macroeconomic theory says that permanent phenomena are supply shocks, not demand shocks. I realize that Larry Summers has floated the idea of “secular stagnation” on the demand side, but if this has already become a generally accepted thesis then I missed the memo.

c) Brad’s political economy appears to assume that rich people knew that we were suffering from secular stagnation five years before Larry did.

One of the points that I emphasize in my book (which is almost finished, by the way), is that the last few years we have seen a lot of on-the-spot macroeconomic theorizing that differs considerably from what was taught prior to the crisis. That’s fine. We need it. If you feel like stoning to death DSGE models and their kin, I’m happy to join in. But by the same token, I believe that new, outside-the-box thinking has to be marketed as tentative and speculative, not as scientific truth that only the evil or ignorant would deny.

Business Births and Deaths

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A reader kindly sent me a spreadsheet with data from the business dynamics survey, in order to see if one can locate periods that correspond to the quadrant here. Some remarks on the data.

1. The rate of entry of new businesses (new businesses started per year as a percentage of existing businesses) was much higher in the late 1970s and in the 1980s than in subsequent years. One can tell stories for this, of course, but it is not what I would have expected.

2. The rate of entry of new businesses from 1994-2007 ranged from a low of 11.4 percent in 2000 to a high of 12.9 percent in 1997. In contrast, the figures for 2008-2011 were 10.4, 9.0, 10.0, and 10.4 percent, respectively.

3. The rate of exit of businesses from 2008-2011 was not too much higher than that in the 1994-2007 period. For the most part, the exit rate stayed between 10.0 percent and 11.9 percent from 1994 through 2011. The exceptional years were 2003-2005, when the exit rate was less than 10 percent.

The year 2009 stands out as a year of low creation and high destruction. This is consistent with the Minsky Recession story, but one could always choose to call it an aggregate demand story.

Toward a New Macroeconomics, Part Two

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The creation/destruction matrix tells us about employment. What about inflation?

In my view, there is no reliable Phillips Curve. Also, the behavior of velocity means that the monetary authority cannot precisely control inflation (or nominal GDP). Instead, there are three regimes for inflation.

1. Anchored expectations. People expect inflation to be low. When the central bank alters the money supply, velocity tends to move in an equal and opposite direction.

2. Hyperinflation. The fiscal deficit is out of control. Government spending far exceeds what the government is able to take in through taxes and borrowing. Money is printed at an ever-accelerating rate, and its velocity rises as households and businesses try to minimize their losses from holding money. The private sector becomes reluctant to use money at all, and its use becomes increasingly confined to transactions with the government.

3. Inflation fever. As in the U.S. in 1970-1985, inflation reaches a level where it becomes a major factor in the financial planning of households and businesses. They put cost-of-living escalators into contracts. They adopt financial innovations that allow them to minimize holdings of non-interest-bearing money, creating upward lurches in the velocity of money. This behavior in turn reinforces inflation, producing a vicious cycle of high and variable inflation.

In terms of the monetarist equation, MV = PY, I view velocity has highly unstable. When inflation expectations are anchored, monetary policy is ineffective because of offsetting movements in velocity. Under hyperinflation, there is no independent monetary policy–money is printed to fund the government debt. When there is inflation fever, velocity is high and variable, and the monetary authorities can do little about this. In the early 1980s, perhaps Paul Volcker was able to turn things around. Or perhaps the bond market vigilantes, by raising long term real interest rates, boosted the value of the dollar and brought down oil prices, thereby breaking the inflation fever.

Toward a New Macroeconomics, Part One

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This is a concise summary of what I currently believe.

Low Creation High Creation
Low Destruction Corporatist Stagnation Schumpeterian Boom
High Destruction Minsky Recession Rising Dynamism

There is high creation when new businesses are launching and growing at a high rate. There is high destruction when incumbent businesses are disappearing at a high rate.

When the incumbents use government power to hang on, we have corporatist stagnation. That would be my diagnosis for Europe starting in the 1980s and Japan starting in the 1990s. The U.S. is at risk of falling into that quadrant.

Schumpeter describes a boom in which new businesses are emerging but incumbent businesses have not yet gotten the memo. You get Amazon growing while legacy bookstores remain.

A Minsky recession describes what we have seen in the U.S. in the last five years. Minsky said that when you have a financial crisis, businesses try to minimize outside funding and live off profits. Mark Perry shows what happens as a result.

The fact that the US economy is producing 5.6% more output now than in 2007 with 2 million fewer workers would explain why corporate profits are at record levels and more than 40% above the pre-recession peak (not adjusted for inflation).

Rising dynamism describes the U.S. in the 19th century, Japan in the 1960s and 1970s, and China more recently. Old patterns of economic activity are rapidly giving way to new ones.

David Andolfatto on Asymmetry

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He writes,

the labor market is a market for productive relationships. It takes time to build up relationship capital. It takes no time at all to destroy relationship capital.

Pointer from Mark Thoma. Note that this should make firms hesitant to fire workers, because of the cost of having to re-fill the position if it turns out that it was needed. I believe that this reinforces the asymmetry.

Phillips Curve Specifications and the Microfoundations Debate

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Scott Sumner writes,

As you may know I view inflation as an almost worthless concept… In contrast Krugman discusses the original version of the Phillips curve…which used wage inflation instead of price inflation. Whereas price inflation is a useless concept, wage inflation is a highly useful concept.

Fine. But Krugman also draws attention to how the level of the unemployment rate affects the level of the wage inflation rate. This takes us back to the original, pre-1970 Phillips Curve, from Act I in my terminology (Act I was the Forgotten Moderation, from 1960-1969, Act II was the Great Stagflation, from 1970-1985. Act III was the Great Moderation, from 1986-2007, and Act IV is whatever you want to call what we are in now.) The Act I Phillips Curve says flat-out that (wage) inflation will be high when unemployment is low, and vice-versa.

The Phillips Curve was revised in Act II, when the specification became that the rate of wage inflation increases when the unemployment rate is above below the NAIRU and decreases when it is belowabove the NAIRU. In other words, it relates the change in the rate of wage inflation to the unemployment rate. At the time, cognoscenti were saying that Friedman had moved the Phillips Curve one derivative.

Some comments.

1. The Act I Phillips Curve works better over the 27-year period (Acts III and IV) that Krugman covers. Within the sample period, in 9 out of the 10 years when unemployment is near the bottom of its range (less than 5 percent), wage inflation is near the top of its range (3.5 percent or higher). In all three high-unemployment years, wage inflation is less than 2.5 percent.

2. Although the rate-of-change in wage inflation is also correlated with the unemployment rate, the relationship is not as impressive. In the late 1990s, we had the lowest unemployment rate, but wage inflation actually declined (admittedly by only a small amount). More troubling is the fact that the very high rate of unemployment in recent years produced a decline in wage inflation hardly larger than that of the much milder previous recessions.

3. The overall variation in wage inflation over the 27 years is remarkably low. It ranges from 1.5 percent to 4 percent. When there is this little variation to explain, the actual magnitude of the effect of variations in unemployment on inflation is going to be pretty small. See the post by Menzie Chinn. If you do not have any data points that include high inflation, then you cannot use the Phillips Curve to explain high inflation. Chinn argues that the relationship is nonlinear. I would say that we do not know that there exists a nonlinear relationship. What we know is that we observe a relationship that, if linear, has a shallow slope. The most we can say is that if there is a steep slope somewhere, then there is a nonlinear relationship.

4. If you had given a macroeconomist only the information that wage inflation varied between 1.5 percent and 4 percent, that macroeconomist would never have believed that such a time period included the worst unemployment performance since the Great Depression. In terms of wage inflation, the last five years look like a continuation of the Great Moderation.

Some larger points concerning market monetarism, paleo-Keynesianism, and the microfoundations debate:

5. Concerning Scott’s view of things, I have said this before: Arithmetically, nominal GDP growth equals real GDP growth plus growth in unit labor costs plus the change in the price markup. If you keep the price markup constant and hold productivity growth constant, then nominal GDP growth equals real GDP growth plus wage growth. So it is nearly an arithmetic certainty that when nominal GDP grows more slowly than wages, then real GDP declines. But to me, this says nothing about a causal relationship. You could just as easily say that a decline in real GDP causes nominal GDP to grow more slowly than wages. What you have are three endogenous variables.

Scott insists on treating nominal GDP growth as the exogenous variable controlled by the central bank. To me, that is too much of a stretch. I am not even sure that the central bank can control any of the important interest rates in the economy, much less the growth rate of nominal GDP. Yes, if they print gobs and gobs of money, then inflation will be high and variable, and so will nominal GDP growth. But otherwise, I am skeptical.

6. I view paleo-Keynesianism as being hostile to Act III macro. I share this hostility. However, right now, you have saltwater economists saying, “Freshwater economists reduce macroeconomics to a single representative agent with flexible prices solving stochastic calculus problems. Hah-hah. That is really STOOpid.”

The way I look at it, the Act III New Keynesians reduced macroeconomics to a single representative agent with sticky prices solving stochastic calculus problems. They should not be so proud of themselves.

Paul Krugman calls Act III macro a wrong turn. (Pointer from Mark Thoma.) I would not be so kind. I also would not be as kind as he is to the MIT macroeconomists who emerged in that era.

You cannot just blame Lucas and Prescott for turning macro into a useless exercise in mathematical…er…self-abuse. You have to blame Fischer and Blanchard, too. Personally, I blame them even more.

Having said all that, I do not share Krugman’s paleo-Keynesianism. Just because the Lucas critique was overblown does not mean that other critiques are not valid. I have developed other doubts about the Act I model, and these lead me to believe that PSST is at least as plausible a starting point for thinking about macro.