Category Archives: PSST and Macro

Janet Yellen in 2009

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In a comment on this post, Mark Thoma pointed out that Janet Yellen’s views have changed since 2005. In this piece from 2009, she says

the hand we have been dealt today doesn’t look anything like the textbook ideal that I just described. Instead, we are experiencing pervasive financial market failures with devastating macroeconomic effects. The normal monetary transmission mechanism has been hobbled by dysfunctional money and credit markets. Risk spreads have ballooned on supposedly safe assets like agency debt and mortgage-backed securities (MBS). What does optimal monetary policy look like in this situation? How do we gauge the effectiveness of policy actions, and how can we implement and communicate systematic policy responses under these conditions?

What strikes me is that Yellen’s views in 2005, that I cited in the earlier post, closely reflected the consensus point of view at that time. And the 2009 speech closely reflects the consensus view at that time.

Today, the problem for the 2009 consensus view is that financial markets recovered really well by the Spring of 2009, but the labor market, particularly as measured by the civilian employment/population ratio, has failed to recover. So now, macroeconomists are struggling to explain how a financial crisis five years ago could still be causing high unemployment today. (Of course, Reinhardt and Rogoff warned that the recovery would be slow, but other economists have challenged their view that financial crises produce slow recoveries.) Do we think that the new consensus will be “secular stagnation” and that Janet Yellen will once again join it?

Mark Thoma on Different Macro Models

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He writes,

The New Keynesian model was built to explain a world of moderate fluctuations in GDP. It features temporary price rigidities, and the macroeconomic aggregates in the model are consistent with the optimizing behavior of individual consumers and producers. For certain types of questions – how should policymakers behave to stabilize an economy with mild fluctuations induced by price rigidities – it is the best model to use. Hence it’s popularity during the “Great Moderation” from 1984-2007 when there were no large shocks to the economy…

The IS-LM model, on the other hand, was built in the aftermath of the Great Depression to examine precisely the kinds of questions we faced throughout the Great Recession, issues such as a liquidity trap, the paradox of thrift, and how policymakers should react in such an environment. Why is it surprising that a model built to explain a particular set of questions does better than a model built to explain other things?

Read the whole essay. My guess is that even those who are inclined to be sympathetic to Thoma on this point, myself included, will have a hard time accepting the idea that one should switch models depending on circumstances. Yet I would argue that the evidence is that economists have done exactly that over the past 50 years.

Macro Wars: They’re Ba-a-a-ack!

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Two pointers from Mark Thoma.

1. Simon Wren-Lewis writes,

An alternative and I now think better, vision would give more emphasis to how economics developed. Economic history would play a central role. Economic theory would be seen as responding to historical events and processes. For example placing Keynesian theory in the context of the Great Depression is clearly useful, given the events of the last five years. I think it is also important to recognise the links between economic theory and ideology. This is partly to understand why governments might not act on the wisdom of economists, but it also leads naturally to recognising that economists need to adapt to the social and political context in which they work. We should also be more honest that our wisdom might be influenced by ideology. Given the limits to experimental and econometric evidence, but with a very clear axiomatic structure, methodology is always going to be an important issue in economics.

Which reminds me, I need to recover the momentum on the book I am writing.

2. Miles Kimball and Noah Smith write,

Patrick Kehoe, one of the economists dismissed from the Fed, is a key figure in a school of economics called “Freshwater Macroeconomics” (the other, Ellen McGrattan, is his frequent co-author). The labels “Freshwater” and “Saltwater” go back to the arguments and new ideas generated by the double-digit inflation in the 1970s.

I wrote about this conflict over a decade ago. Back then, I considered myself on the freshwater side. Now I am more “a pox on both your houses.”

Kimball and Smith describe the appeal of each school of thought. My book will attempt to do that, also. But I also will explain why I came to reject both schools and instead turn to PSST.

Secstag: All Things to All People?

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Daniel Davies writes,

The US economic policy structure was aware that they were accommodating China and NAFTA, and aware that the tool of demand management was consumer spending. They might or might not have been aware that the consumer spending was financed by borrowing against housing wealth, but if they weren’t, they thundering well should have been. They got a structural increase in personal sector debt because they wanted one and set policy in order to create one. There’s no good calling it a “bubble” or a “puzzle”

Pointer from Tyler Cowen. Read Davies’ entire post.

We have the basic identity

S – I = (T-G) + (X-M)

That is, the excess of domestic savings over investment equals the government surplus plus the trade surplus. This is true whether we are in a recession, a boom, or anywhere in between.

What Davies seems to be saying is that China wanted a lot of (X-M), which gave us a big negative (X-M). Holding (T-G) constant, this gives us a big negative S-I. Since we didn’t do much I, we did a lot of dissaving. And this drop in personal saving is yet another meaning for the very plastic phrase “secular stagnation.”

Oy. Scott Sumner comments,

There can’t be a structural shortage of demand, because demand is a nominal concept.

For decades after The General Theory, there were arguments over what Keynes really meant. Seeing what Larry Summers has unleashed, one can understand how this happens. At a time when economic performance is disappointing and people are groping for explanations, a guy who is known to be a great economist offers an answer that is vague but sounds clever. He then leaves it to other people to come up with a precise version. Unfortunately, the precise versions are problematic, meaning that they are either unsound in terms of theory, inconsistent with evidence, unable to support the explanation and policy implications of the vague version, or all three. We proceed to cycle back-and-forth between the clever-sounding vague version and the precise, problematic versions.

Olivier Blanchard on the Macroeconomic Consensus

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He writes,

Turning to liquidity provision: in advanced countries (but, again, the lesson is more general), we have learned that runs are relevant not only for banks, but also for other financial institutions, and for governments. In an environment of high public debt, rollover risks cannot be excluded. An implication, and one of the themes emphasized by Paul Krugman, is that it is essential to have a lender of last resort, ready to lend not only to financial institutions but also to governments. The evidence on periphery sovereign bonds in the Euro area, pre and post the European Central Bank’s announcement of outright monetary transactions, is quite convincing on this point.

I cannot say that I agree. In fact, I cannot say that I agree with a single point that he makes in the essay. But he represents the consensus.

Scott re-interprets Larry

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Scott Sumner writes,

Summers claims that some sort of exogenous shock has reduced the long run real interest rate on safe assets.

That is not what I heard. Go back and listen to Larry’s response to Jeff’s question. Larry is talking about a savings glut and a decline in the cost of physical capital.

Think of an economy with three assets: money, risk-free Treasuries, and physical capital. What I heard Larry saying was that because of the savings glut and the low price of computers, the full-employment real return on physical capital is negative. That is a silly idea and a false idea, but that is what I heard Larry say. Ben Bernanke heard the same thing.

What Scott heard Larry say was that the demand for risk-free Treasuries is high, but the demand for physical capital is not so high, so that there is still a sizable risk premium on risky assets. My comments:

1. That may be a good story for, say, the fourth quarter of 2008. Larry claims to be talking about a decades-long phenomenon, pre-dating the crisis and continuing into the indefinite future.

2. The policy implications of that story are somewhat different than the policy implications of “secular stagnation.” If there is too much savings, then Larry wants to argue that the government needs to use up the savings. If what is holding back investment is high risk premiums, then more government spending is not such an obvious remedy.

Jeff Sachs vs. Summers/Krugman

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He writes,

Keynesians like to say that there is a savings glut (an excess of saving over investment). They try to remedy it by spurring consumption. This is a mistake. There is an investment shortfall, because the financial, regulatory, and policy barriers to high-return investments have not been addressed. America urgently needs investments in modernized infrastructure, advanced science and technology, and job skills appropriate for the 21st century. We are sitting on top of an information revolution and nanotechnology revolution that could positively reshape healthcare, education, transportation, low-carbon energy systems, green buildings, water conservation, and environmental safety.

Pointer from Mark Thoma. Sachs and I would probably disagree about the proportion of the solution that consists of government leading vs. getting out of the way. However, his diagnosis seems to me to make some sense, unlike the savings glut story.

Secular Stagnation? Seriously?

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Paul Krugman endorses the idea. Pointer from Mark Thoma.

My own first reaction to Larry Summers’ talk was to write

there are so many problems with Summers’ story that one does not even know where to begin.

Tyler Cowen writes,

I don’t mean this in a rude or polemic way, but the arguments we have been reading do not yet make sense.

Cowen’s stagnation story is that the pace of innovation has slowed, resulting in declining growth in aggregate supply. In contrast, Summers’ story is one of a permanent shortfall of aggregate demand, due to an excess of desired saving over desired investment, which can only be eliminated at a negative real interest rate.

Here are some criticisms that come to mind.

1. If “the” full-employment real interest rate is negative, then why do we need quantitative easing? Why does not the excess of saving over investment not by itself drive long-term rates to zero?

2. Summers wants to claim that full employment has been achieved in recent years because of asset bubbles. However, in a world of negative real interest rates, there is no such thing as an asset bubble. Real assets have infinite value in such a world.

3. As Tyler points out, it is hard to reconcile positive economic growth with negative real interest rates. We have had positive economic growth, even since 2008.

4. As Tyler also points out, we observe higher interest rates for risky assets. In fact, if you want to understand the low interest rates that Summers and Krugman are talking about, then my suggestion is to “follow the guarantees.” In one way or another, the U.S. government has provided a guarantee on many investments. Government bonds are one example. Mortgages are another.

5. The prime rate at banks averaged 5 percent from 2001-2004, almost 7 percent from 2005-2008, and 3.25 percent from 2009-2012. Inflation over these periods averaged 2.3 percent, 3.4 percent, and 1.5 percent respectively, so that the real rate of interest has been positive throughout.

6. Summers’ revival of the secular stagnation hypothesis has not been broadly peer reviewed. Before people jump on the bandwagon, I would wait until it has been evaluated by a broader range of economists.

Low Interest Rates

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Why are long-term nominal interest rates still low (the ten-year Treasury is about 2.7 percent)? I think that two of the standard explanations cause difficulties for the PSST view. Consider:

1. The Fed is doing it. This is problem because from a PSST perspective, the Fed should have very little effect on interest rates, particularly long rates. Yes, I know that the Fed is intervening in long-term credit markets, but it is still not a large player relative to total debt outstanding.

2. There is weak aggregate demand. This works well from an AS-AD perspective, but not from a PSST perspective.

Here are the explanations that might be consistent with PSST.

3. We are experiencing a bond bubble. A lot of irrational investors (foreign, perhaps?) are pushing bond prices higher than they ought to be.

4. Inflation is over-stated, particularly in the U.S. The prices of internationally tradable goods are falling. So the real interest rate is actually high. The rise in official inflation measures is in sectors like health care and college tuition, and there are no leveraged plays in those sectors. (If prices were rising for manufactured goods, you could borrow money to build factories and make lots of money. There is no comparable way to take advantage of rising college tuition or health care spending.)

I think I like (4) the best. What it suggests is that if you have your savings in a money market fund earning very low interest, you are actually doing well, as long as you do not face paying for college or paying for your own health care. Your personal cost of living is probably falling. What should concern you is the possibility that the government will find it necessary to adopt much more inflationary policies in order to pay its bills. If that happens, you will need some real assets in order to avoid having your savings wiped out.

The graduate/undergraduate dichotomy

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Nick Rowe writes,

What should the government do, if there is an increased desire to save, and the central bank is unable or unwilling to cut real interest rates enough to offset it? The answer is that the government should cut the growth rate of government spending, to shift the IS curve left, which raises the natural rate of interest (i.e. prevents it falling), because the IS curve slopes up when we have the growth rate of transitory income on the axis…

Fiscal policy in Old and New Keynesian models is even more different than John Cochrane thinks it is. And understanding why is hard.

Read the whole thing. It is graduate-school macro, which is harder than undergraduate macro.

I will just toss in a wrinkle, which is that in these sorts of models, sometimes the way to cut the growth rate of something is to increase its level immediately. So “cutting the growth rate of government spending” can mean immediately jumping to a high rate of government spending, from which you then have a slower growth rate.

There are various dichotomies in macro. The classical dichotomy separates nominal from real. The money supply only affects nominal variables (the price level) while leaving real variables (real wages, real GDP) unaffected. The crude Keynesian dichotomy is between prices and quantities. Instead of intersecting supply and demand curves, you have quantities affecting quantities. Spending creates jobs, and jobs create spending. Prices adjust to wages, and wages adjust to prices, but neither adjusts to employment or output.

Another dichotomy is between undergraduate and graduate macro. In undergraduate macro, fiscal policy works the way old Keynesian intuition says it works–by injecting spending into the economy. In graduate macro, fiscal policy works in these weird ways of twisting the path of desired consumption.

In communicating with other academics, a Keynesian economist will manipulate these dynamic optimization equations and derive a result that says that “fiscal policy works.” But when the economist communicates with undergraduates and other ordinary mortals, they hear a completely different story–basically Old Keynesian.

For the record, I think both stories have serious problems. The problem with the Old Keynesian story is that it rules out by assumption the operation of the adjustment mechanisms that we ordinarily take for granted, in which prices respond to excess supply and demand, and resources shift in response to profits and losses. However, I will still respect you in the morning if you say you are an Old Keynesian who believes that those adjustment mechanisms operate only very slowly in the real world. You can get from there to my PSST view by simply adding the proposition that throwing more M or G at the economy does nothing to speed up this adjustment process.

I have less respect for New Keynesians. (1) Although in a charitable mood I can try to pass a Turing test as a defender of the need for “microfoundations,” in my heart of hearts I believe that these representative-agent, dynamic optimization models are a useless exercise in mathematical masturbation. (2) In policy discussions, New Keynesians seem to gloss over how their models work, wave their hands, and deliver that Old-time Keynesian religion, hoping that nobody will call them out on it. Unfortunately for them, John Cochrane and Nick Rowe are around to try to keep them honest.

You should also read Brad DeLong and Paul Krugman on this topic. My sense is that they regard New Keynesians as useful idiots. But I think that they actually prefer something closer to Old Keynesianism. I would if I were them.