Category Archives: PSST and Macro

Antonio Fatas Starts a Discussion

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He wrote about what he sees as four missing ingredients in mainstream macroeconomics. Let me focus on his last two:

There is plenty of evidence that price rigidities are important and they help us understand some of the features of the business cycle. But there must be more than that. There are other frictions in the real economy that produce a slow adjustment and are responsible for the persistence of business cycles.

… The notion that co-ordination across economic agents matters to explain the dynamics of business cycles receives very limited attention in academic research.

Robert Waldmann adds,

I think the problem is that with coordination failures, multiple equilibria are possible. Not just two or two hundred either, but a large infinite number. There is no theory which tells us how likely different equilibria are. Worse, policy shifts can cause the economy to jump from one equilibrium to another in unpredictable ways.

This does not strike me as an argument against the validity of models of coordination failure. In fact recessions are hard to predict and, well, look like panics. The problem is that models which say that macroeconomists will not be able to predict well are not popular.

Pointer from Mark Thoma.

When I wrote one of my PSST papers, Peter Howitt’s response put it in the coordination failure literature. In fact, I think there is a (possibly slight) difference. “Coordination failure” sounds to me as if there is a great equilibrium sitting there, and people just cannot find it. I think that the patterns of sustainable specialization and trade need to be discovered, through trial and error.

I believe that even if there were no frictions impeding coordination, as long as entrepreneurs have to test business models without knowing whether they will work, there will be business models that fail and unemployment can result. However, this is a weird hypothetical, since there is obviously no such thing as an economy with frictionless coordination.

So my view of what macro needs would include coordination failure of a variety of types, as well as trial-and-error learning. In my opinion, the resistance to this comes from various sources:

1. As Waldmann says, you have multiple equilibria. In fact, you never get to any one equilibrium, so that the very notion of equilibrium as a core modeling element loses salience. That creates a ton of discomfort.

2. The system is no longer hydraulic, in which more X (fiscal stimulus, monetary growth) leads to proportional increases in Y (GDP, inflation, employment). For many macroeconomists, the whole point of modeling is to come up with implications for fiscal and monetary policy. The idea that your model may not lead to a cure for business cycle makes the effort seem pointless, at least in compared with Keynesian can-do thinking.

3, It is inconsistent with popular modeling simplifications, such as the “representative agent.” For the purpose of publishing papers in journals, economists like to gravitate toward standard models. It is much easier to get published if you do a variation on a standard model than if all the people working on an idea are just groping around in different ways. I think that the coordination-failure approach to macro involves this disparate groping, and thus it suffers from….a co-ordination failure, if you will. The DSGE folks can co-ordinate. The rest of us can’t. So even though the DSGE stuff is a blind alley we have better ideas, when it comes to the journal process, we lose.

Normal AD vs. the Credit Channel

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‘Uneasy Money’ writes,

try as they might, the finance guys have not provided a better explanation for that clustering of disappointed expectations than a sharp decline in aggregate demand. That’s what happened in the Great Depression, as Ralph Hawtrey and Gustav Cassel and Irving Fisher and Maynard Keynes understood, and that’s what happened in the Little Depression, as Market Monetarists, especially Scott Sumner, understand. Everything else is just commentary.

Pointer from Tyler Cowen. This argument broke out five years ago, and it is no closer to being settled. I might phrase it as the following multiple choice question:

a) the economic slump caused the financial crisis (the Sumnerian view, endorsed above)

b) the financial crisis caused the slump (the Reinhart-Rogoff view; also the mainstream consensus view).

c) both are symptoms of longer-term structural adjustment issues (I am willing to stand up for this view. Tyler Cowen also is sympathetic to it. Note that I do not wish in any way to be associated with Larry Summers’ view, which is that the structural issue is that we have too much saving relative to productive investments.)

d) both are symptoms of a dramatic loss of confidence. As people lose confidence in some forms of financial intermediation, intermediaries that are heavily weighted in those areas come to grief. Se see disruptions to patterns of trade that depend on those forms of intermediation. Moreover, as businesses lose confidence, particularly in their ability to access credit, they trim employment and hoard cash.

I want to emphasize that I see a reasonable case to be made for any of these views. There may be yet other points of view that I would find reasonable (although Summers’ “secular stagnation” is not one of them). In macroeconomics, if you think you have all the answers, then I cannot help you. I think that this is a field in which doubts are more defensible than certainties.

The Flat Tire as Discontinuity

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From the current draft of my macro book:

The gas pedal is a metaphor for continuity. The flat tire is a metaphor for discontinuity. If the economy is characterized by continuity, then in the absence of a large shock, it cannot suddenly “jump” from one state to a very different state. Typically, macroeconomic models embody continuity, so that they do not allow for sudden jumps. To do so, a model must incorporate multiple equilibria, or what I would prefer to call discontinuity.

…With respect to perception and reality (or liquidity and solvency), a firm might be in one of three states:

1) insolvent under all circumstances. Investors with funds at risk with the firm are going to experience losses, whether they realize it or not.

2) solvent under all circumstances. Even if investors were to lose confidence in the firm, it would be able to meet its obligations to them.

3) solvency contingent on investor perceptions. If investors maintain confidence, so that the cost of short-term funding is low, the firm’s net worth is positive. However, if investors lose confidence and the cost of short-term funding rises, the firm’s net worth would become negative.

It may be the norm for financial institutions to be in state (3), meaning contingent solvency. They are solvent if their investors remain confident, but they are insolvent otherwise.

…If banks are normally in a state of contingent solvency, then there arises the possibility of discontinuity in the financial sector. A relatively modest adverse shift in perceptions, by causing a run, can lead to a large decline in both liquidity and solvency among affected banks. This can cause a sudden drop in financial intermediation.

Macroeconomic Changes

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From an article bySerena Ng and Jonathan H. Wright (gated)

There has been a secular increase in the share of services in consumption from an average of 50 percent before 1983 to 65 percent after 2007, at the expense of nondurables (from 35 percent to 22 percent). Labor share in the nonfarm sector has fallen, as has the share of manufacturing employment. The civilian labor force participation rate stands at 63.5 percent in 2013, much below the peak of 67.2 percent in 1999. This is in spite of the female participation rate rising from under 35 percent in 1945 to over 60 percent in 2001, as the male participation rate has been falling since 1945. The economy has experienced increase openness; international trade and financial linkages with the rest of the world have strengthened, with the volume of imports plus exports rising from 12 percent of GDP before 183 to 27 percent post-2007. Meanwhile, not only have households’ and firms’ indebtedness increased, so has foreign indebtedness. For example, the household debt-to-asset ratio rose from under 0.75 in the 1950s to over 1.5 in 2000 and has since increased further. Net external assets relative to GDP have also risen from 0.82 in the 1970s to 2.4 when the sample is extended to 2007.

Keep in mind that the conceit of macroeconometrics is that each quarter is an independent observation, and that by controlling for a few variables one can make, say, 1982 Q1, equivalent to 2009 Q3, except for key policy drivers. If you cannot buy that (and of course you cannot), then I believe that you have reasons to be skeptical of any purported estimates of multipliers.

Is the Flat Tire an AD Shock?

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I recently suggested that if the economy is a car and monetary policy is the gas pedal, then perhaps the financial crisis was a flat tire. Keeping with the metaphor, we can ask.

1. Was the flat tire fixed by early 2009?

2. Was the flat tire an AD shock? Can monetary and fiscal expansion restore full employment?

I think that the mainstream view is “yes” to both questions. Of course, that depends on how one interprets the flat tire. If one interprets it as troubled banks and a high TED spread, then it was fixed. In that case, I am not sure how you would explain why the the macroeconomic problems lasted five years.

Perhaps it is more promising to say that the flat tire was not fixed by early 2009. Maybe the best one can say is that it was patched before even more was let out of it. Yes, the banks did not collapse, but financial confidence remained low, as reflected in tighter credit conditions for mortgage loans and business loans (can we really demonstrated the latter)?

I find it more promising still to suggest that the flat tire was a broader loss of confidence. Confidence in certain types of financial transactions fell. But it also fell in business in general. So older businesses rushed to let go of excess workers, and entrepreneurs did not rush to form new businesses.

So my inclination is to say “no” to both questions. Perhaps the air stopped running out of the tire, but it was not really fixed. Also, I do not think that it helps to view the economy as suffering from an AD shock. If the financial sector is not functioning properly, and the analogy is with having a nation-wide electrical power failure (as Larry Summers suggested in his “stagnation” talk), then that is more of supply-side issue. Moreover, if some businesses are shedding excess workers while other businesses are not hiring, then that is a PSST issue.

Possibly related, here is Timothy Taylor on Alvin Hansen. Taylor concludes,

I worry that the current U.S. economic policy agenda is all about fiscal and monetary policy, along with financial regulation and health insurance. I hear relatively little discussion focused directly on an agenda for creating a supportive environment for private domestic investment.

Forgotten Macroeconomic History

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From Paul Volcker, interviewed by Martin Feldstein in the Journal of Economic Perspectives.

[Early in 1980, President] Carter was obviously under pressure, so he triggered a provision of law that
permitted the Federal Reserve to put on credit controls…We said, “Okay, you’re going to have a reserve requirement on credit cards—if credit cards exceed past peaks, you would have a reserve requirement.” We did that knowing, we’re now in March, the peak in credit card use comes in November and December. We were way below it so there was no possibility that this was going to become a factor for some time…The economy at that point fell like a rock. People were cutting up credit cards, sending in the pieces to the President as their patriotic duty. Mobile home and automobile sales dropped within the space of a week or so. The money supply, we didn’t know why the money supply was dropping, but all of the sudden the money supply was down 3 percent in a week or something…Well, it was a recession alright, the economy went down, but it was an artificial recession. As soon as we took off the credit controls in June, the economy began expanding again

Credit rationing seems to be quite powerful. Recall that before the late 1980s, interest-rate regulations ensured that when interest-rates rose, the depository institutions would find themselves without money to lend for mortgages, and that was usually enough to bring about a recession.

Business Psychology, Business Reality, AD-AS, and PSST

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Nick Rowe writes,

For an open economy, like Canada, a lot of our PSSTs are with foreigners. Americans especially. That’s why Canadian recovery depends on US recovery, even though we have our own monetary policy so we can make our own AD curve shift independently of the US AD curve, if we want to. The Canadian recovery has been slow because the US recovery has been even slower. We can’t rebuild some of our PSSTs until the Americans rebuild some of theirs. We are waiting for the Americans to join in our cross-border PSSTs.

One way to think about PSST vs. AD-AS is to think about reversible or irreversible shifts in patterns of specialization and trade. If it’s reversible, then AD-AS is probably the best way to think about it. Because of excess inventory, housing construction and durable goods manufacturing are cut back, but that gets reversed when inventory/sales ratios get back down to normal levels. If it’s not reversible, then PSST may be the best way to think about it.

Now, on to business psychology and business reality.

If you like the old paradigm, then think of business psychology as if it were aggregate demand and business reality as if it were aggregate supply.

In business reality, opportunity can be high or low, and adversity can be high or low. Four possibilities for the overall state of business reality:

1. High-opportunity, low-adversity would describe an economy unleashed. This is a rare combination. Maybe the U.S. in the post-WWII hegemonic period? Maybe the parts of the Chinese economy that were freed by reforms? There are lots of opportunities to create new patterns of sustainable specialization and trade, but old patterns are not heavily threatened.

2. Low-opportunity, high-adversity. This typically reflects major government policy mistakes. Wage-price controls in the U.S. in the early 1970s? Hyperinflation in Zimbabwe. There are few opportunities to create new patterns of sustainable specialization and trade, and old patterns become unprofitable.

3. High-opportunity, high-adversity. This would be a very dynamic economy. The 1920s in the U.S.? 1990-2007 in much of the world? New patterns of sustainable specialization and trade are created, while old patterns break down.

4. Low-opportunity, low-adversity. This would be a relatively stagnant economy. Think of sectors where regulation restricts entry (health care and education come to mind). It’s hard to get into business and hard to be driven out of business.

Now, superimpose on this business reality the state of business psychology. Are entrepreneurs highly attuned to opportunities, or are they relatively timid? Are incumbent businesses highly attuned to adversity, or are they relatively blithe? These psychological conditions affect overall employment. The four possible psychological conditions:

1. High-opportunity, low-adversity. Something like the late 1990s, when new firms are chasing opportunities but old firms are not seeing the handwriting on the wall (Amazon expands, but Borders does not realize that its under threat).

2. Low-opportunity, high-adversity. You have the 1930s, or the past five years. Old firms are firing, because they are very attuned to adversity, but new firms are not thriving and growing.

3. High-opportunity, high-adversity. The economy is dynamic, and everybody knows it. Rapid restructuring takes place. The telecom industry in the U.S., where hundreds of thousands of telephone operators lost their jobs, but the cell phone industry created even more jobs.

4. Low-opportunity, low-adversity. An economy that tunes out the dynamism in the world. The economy fails to restructure, but few people get fired. Japan in the 1990s?

Note that this is close to the way Schumpeter thought about things. Note that “stagnation” can be primarily in business reality (#4 in the first list) or primarily in business psychology (#2 in the second list). Possibly both.

Normal Macro and Financial Crises: Road Friction and Flat Tires

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Economists these days seem to want to describe two financial regimes. One is a “normal” regime, which can be regulated by conventional monetary policy. The other is a “crisis” regime, which cannot. Here is a metaphor to think about:

Imagine the economy as a car, with Fed monetary policy consisting of pressing on the accelerator pedal. The Fed tries to maintain a constant speed, and sometimes that means pushing hard on the accelerator and other times it means letting up. In the normal regime, the Fed just deals with road friction and hills.

In the crisis regime, the car has a flat tire. The Fed can press really hard on the accelerator pedal, and yet the car is not going to go as fast as people want.

Until recently, macroeconomic theory focused on the normal regime, dealing with road friction and hills. What are the microfoundations? What policy rules work best? etc.

But what about the crisis regime? Scott Sumner’s view would be that there is no such regime. He would say that we are seeing a normal regime in which the Fed has stubbornly failed to press hard enough on the accelerator pedal.

When I hear mainstream economists praise TARP, I think they believe that troubled banks were the macroeconomic equivalent of a flat tire, and you needed TARP to patch the tire. Perhaps this is correct. However, I do not think we can tell this story very well by using the models that were designed to describe the normal regime. As of now, I think that there is a huge gap between mainstream intuition, which thinks in terms of the flat tire, and mainstream modeling, which deals with road friction. In particular, treating financial markets as if they were just another potential source of road friction is probably not going to cut it.

I also do not think that “the zero bound” is the flat tire.

What might be the flat tire is an adverse equilibrium in an economy with multiple equilibria. Think of the economy as having channels of trust. When the channels of trust are open, we have the good equilibrium. When the channels of trust are closed, we have the bad equilibrium. Finance is particularly subject to these multiple equilibria. If people believe that financial instruments are safe, then borrowers can obtain lenient credit at low rates. But in an adverse equilibrium, creditors have doubts, and borrowers are constrained.

In the adverse equilibrium, there is less economic activity. This might explain the intuition that the financial crisis was horrible, and bailing out banks kept things from getting worse. However, it does not necessarily support the intuition that fiscal policy and quantitative easing are helpful.

And I do not necessarily endorse this particular model of the flat tire.

Knowledge, Power, and PSST

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James DeLong invited me to connect the two during the Q&A period here. What I would say is this:

PSST says that in a complex economy, employment fluctuates as unsustainable patterns of trade fall apart and new sustainable patterns get created. In that context, government spending creates new patterns that are unsustainable, such as those in now-failed “green energy” firms that received loan guarantees. The patterns that government creates tend to be unsustainable because of a knowledge-power discrepancy. Government has the power to command resources, but it does not have the knowledge that the market system provides about how to use resources.

So that is the sense in which one might relate the two.

Brad DeLong on Stagnation

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A lengthy, interesting essay. A brief quote:

In the future we are going to want to spend a greater share of our incomes and attention in areas where the market system works less well: information goods, public goods, increasing-returns goods, pensions, health care, education. The market works less well in these areas. But our alternative modes of collective organization, product [sic?] take some bureaucracy, not exactly cover themselves with glory in these areas either. Thus I suspect that not innovation exhaustion but rather institution design will be our big problem in keeping the pace of true economic growth going into the long-run future.

This is where I use my line: “Markets fail. Use markets.”

That is, I do not think that replacing markets where competition works imperfectly with technocrats shielded from competition entirely is the way to go. So while Brad and I might agree that institutional arrangements matter, we disagree on which institutional arrangements are likely to be most promising. I wish we could arrange it so that he lives in his technocratic utopia while I live in a messier decentralized system without having to create an impermeable boundary between us.

But do not let that deter you from reading Brad’s entire essay. One thing that he does well, compared to other discussions I find in the blogosphere and in the press, is wrestle with the meaning of “stagnation.” Too often, I see demand-side stagnation lumped in with supply-side stagnation, even though to me it seems that they are mutually exclusive. You cannot have both excess supply and excess demand at the same time in the aggregate (you can certainly have excess supply in one market and excess demand in another, but that is not what the sloppy thinkers are describing). Of course, I am willing to forget about demand-side issues altogether and just look at everything in terms of PSST.

As Brad also points out, you need to clarify which problems you think are temporary and which problems are embedded in long-term trends. My own view is that the decline in the value of unskilled (and some skilled) labor is embedded in a long-term trend. If there a lot of low GDP-per-worker folks out there, one has to ask whether the best use of their time is working (I think Brad hints at this issue, but perhaps he means something different).

This brings us down to the issue of whether pure innovation is going to be a favorable long-term trend going forward. I am optimistic, but I go back and forth between being more optimistic about information technology vs. biotechnology. I think that improvements in information technology and its applications are easier to achieve but less dramatic. Human biology strikes me as really complex (and perhaps more complex than many researchers were expecting 20 years ago), but the potential payoffs from biotech strike me as huge. For example, I expect chemicals to do much more to improve cognitive ability than any educational tools.