Category Archives: PSST and Macro

Larry Summers, 14.462, and Wealth Illusions

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Thanks to Mark Thoma, I came across a recent IMF Conference honoring Stanley Fischer, who I have called the Genghis Khan of macroeconomics.

If I were you, I would jump to the last video, on policy responses to the crisis. The panel features Ben Bernanke (who wrote his dissertation under Fischer), Fischer, Ken Rogoff (who wrote his dissertation under Dornbusch, but perhaps had Fischer on his committee), and Larry Summers, who went to grad school at Harvard but who spent a lot of time auditing courses at MIT, including Fischer’s monetary economics course, which Summers remembers as being called 14.462 in the MIT catalogue. The panel is chaired by Olivier Blanchard, long-time protege of Fischer, and the first question during the Q&A comes from Jeffrey Frankel, another Dornbusch student. I didn’t find Bernanke or Fischer so interesting, so I would recommend fast-forwarding to minute 33, when Rogoff is speaking.

Rogoff eventually says that one source of financial crisis is ordinary debt. One of the reasons that debt is over-utilized is that it often comes with a government guarantee, either explicit or implicit. One solution he proposes is to get rid of bank deposits. Instead, he would have the Fed run ATMs, and the only transaction accounts people would have would be deposits at the Fed, which I’m guessing would not earn interest. In order to earn interest, people would have to invest in risky securities.. (Rogoff was racing through his talk at this point, so I am doing some interpolation here that might not be exactly correct.)

36 years ago, these were my homies. Rogoff makes some amusing remarks about the macro wars of that time, and I think he correctly pinpoints Fischer and John Taylor as two economists who “bridged” the freshwater and saltwater schools. Later, Summers mocks Minnesota, just as in the old days.

Summers gives the most provocative talk, and it becomes the focus of much of the subsequent discussion. He asks why it was that for the decade prior to the financial crisis we needed the wealth illusions of bubbles in order to maintain an economy even close to full employment. He argues that the full-employment, non-bubble real interest rate must have been below zero for a long time, and that it may remain zero for a long time.

In response to Frankel’s question, Summers says that this situation can be attributed in part to Moore’s Law. Computers as a form of capital are characterized by decreasing prices, and this created a state of chronic excess supply in capital markets. The “savings glut” came not just from foreign sources but from the fact that the cost of obtaining capital in the form of computing equipment kept falling, making investment demand too low to absorb savings.

He is talking about a Great Stagnation not of supply but of demand. As he points out at the start of his talk, nobody has suggested anything like it since the 1940s, with the “secular stagnation” hypothesis. (I think that one of the proponents of that hypothesis was Summers’ uncle, Paul Samuelson, but I may be wrong about that.)

If you start by thinking in terms of classical economics, there are so many problems with Summers’ story that one does not even know where to begin. However, among Fischer’s horde, he is taken seriously. Bernanke does push back, invoking Bohm-Bawerk, as taught to us by Samuelson, to point out the extreme and implausible implications of a negative interest rate.

The panel tends to reinforce my complaints about the homogeneity of professional thinking, which is due, in my view, to Fischer’s over-breeding. These are macroeconomists who became prominent in the 1980s and 1990s. How is it that they constitute the panel here? The equivalent would be watching a panel in 1980 that consisted entirely of economists from the generation that thought wage-price controls were the best tool for fighting inflation.

New and Old Keynesianism

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John Cochrane writes,

The old-Keynesian model is driven completely by an income effect with no substitution effect. Consumers don’t think about today vs. the future at all. The new-Keynesian model based on the intertemporal substitution effect with no income effect at all.

Read the whole thing. He argues, I believe correctly, that advocates of Keynesian stimulus use the old Keynesian model to persuade laymen and policymakers and use the new Keynesian model to fend off other economists. You tell the simplistic “spending creates jobs, and jobs create spending” story to the public, and you tell a mathematically elegant but quite different intertemporal substitution story in academic work.

Wealth Illusions

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From Frederick Taylor’s The Downfall of Money:

In the end, no one really got their money, not even the Americans. Germany used the American loans it received under the 1924 Dawes plan to pay reparations to the French and the British, who in turn used the money to service their own debts to the USA. Then, during the Great Depression, all the major powers, including Germany, France and Britain, effectively defaulted on what they owed to America, and into the bargain the Germans defaulted on reparations.

This reminded me of one of Tyler Cowen’s mantras, that we are not as wealthy as we thought we were. His implied model of recent economic events is that we had illusory wealth during the housing bubble and then reality bites. Some random thoughts:

1. Taylor’s picture of the 1920s suggests a possible wealth-illusion story for the Great Depression. The Germans did not think that they were going to pay anywhere near the full amount of reparations, so they did not count that full amount in their liabilities. However, the Allies were counting on receiving the full amount of reparations (as my previous post on the book indicates, the citizens were led to expect even more than the political leaders were really going to try to collect). In effect, reparations were being double-counted as aggregate wealth, with consumers in the Allied countries counting them as assets but without offsetting liabilities in German households. Then, around 1930, Allied households finally marked down their wealth, and you had the Great Depression.

2. Macroeconomists know that Keynesian fiscal policy effectiveness depends on wealth illusion. The question “Are government bonds net wealth?” must be answered “yes” in order for deficit spending to raise aggregate demand. Otherwise, if Barro-Ricardian equivalence holds (so that the increased wealth of the holders of government bonds is offset by the decreased wealth of households who have marked up their future tax liabilities), then deficits are not clearly expansionary.

3. In theory, wealth illusions do not have to be destabilizing. Economic activity does not have to rise and fall just because people have higher or lower perceptions of wealth. Complete wage and price flexibility would be sufficient to maintain full employment. I am not sure that complete wage and price flexibility is even necessary. However, in practice it seems likely that wealth illusions would prove to be destabilizing.

4. From a PSST perspective, one can imagine all sorts of patterns of trade that depend on perceptions of wealth. When wealth illusions break down, it is not as if all households take an equally proportionate hit. Some households lose more than others. For example, when the housing bubble broke, people who had a lot of their (illusory) wealth in housing lost more than people who did not. So when (illusory) wealth is redistributed, old patterns of specialization and trade become unsustainable, and there will be unemployment until new patterns are established.

5. One could argue that the increase in government debt financed by quantitative easing is fostering a wealth illusion in countries where it is taking place. Indeed, that is in some sense the intent–see point (2). Perhaps we should be more worried than we are about how the process of unwinding this wealth illusion can be accomplished without pain. Actually, I am plenty worried about it.

A Finance Practitioner’s Perspective

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John Hussman writes,

the past 13 years have chronicled the journey of valuations – from hypervaluation to levels that still exceed every pre-bubble precedent other than a few weeks in 1929. If by 2023, stock valuations complete this journey not by moving to undervaluation, but simply by touching pre-bubble norms, we estimate that the S&P 500 will have achieved a nominal total return of only about 2.6% annually between now and then.

He uses the Shiller P/E ratio as his measure of over- or under-valuation. Thanks to Timothy Taylor for the pointer.

What I found even more interesting was a paragraph later in Hussman’s essay.

On careful analysis, however, the clearest and most immediate event that ended the banking crisis was not monetary policy, but the abandonment of mark-to-market accounting by the Financial Accounting Standards Board on March 16, 2009, in response to Congressional pressure by the House Committee on Financial Services on March 12, 2009. The change to the accounting rule FAS 157 removed the risk of widespread bank insolvency by eliminating the need for banks to make their losses transparent. No mark-to-market losses, no need for added capital, no need for regulatory intervention, recievership, or even bailouts. Misattributing the recovery to monetary policy has contributed to a faith in its effectiveness that cannot even withstand scrutiny of the 2000-2002 and 2007-2009 recessions, and the accompanying market plunges. This faith is already wavering, but the loss of this faith will be one of the most painful aspects of the completion of the present market cycle.

And I cannot resist the subsequent paragraph:

The simple fact is that the belief in direct, reliable links between monetary policy and the economy – and even with the stock market – is contrary to the lessons from a century of history. Among the many things that are demonstrably not true – and can be demonstrated to be untrue even with simple scatterplots – are the notions that inflation and unemployment are negatively related over time (the actual correlation is close to zero and slightly positive), that higher inflation results in lower subsequent unemployment (the actual correlation is positive), that higher monetary growth results in subsequent employment gains (the correlation is almost exactly zero), and a wide range of similarly popular variants. Even “expectations augmented” variants turn out to be useless. Examining historical evidence would be a useful exercise for Econ 101 students, who gain an unrealistic sense of cause and effect as the result of studying diagrams instead of data.

The Great Bubble-ation?

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Alex Pollock writes,

Inevitably following each of the great bubbles was a price shrivel. Then many commentators talked about how people “lost their wealth,” with statements like “in the housing crisis households lost $7 trillion in wealth.” But since the $7 trillion was never really there in the first place, it wasn’t really lost.

He has a chart that shows that the biggest financial bubbles of the past 60 years occurred during the period we call the Great Moderation. Thus, during a period of macroeconomic stability, we had financial instability. Hyman Minsky would not have been surprised.

Macroeconomics Without P

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Scott Sumner writes,

I frequently argue that inflation is a highly misleading variable, and should be dropped from macroeconomic analysis. To replace it, we’d be better off looking at variables such as NGDP growth and nominal hourly wage rates.

If we cannot measure P tolerably well, then it sort of spoils the fun about talking about the real wage, the real money supply, or real GDP. I think that the consequence is that we shift all of the focus to:

— the average nominal wage rate, W
–total employment (or hours worked), N

The product of the two, WN, becomes aggregate demand (with NGDP an approximate indicator).

Aggregate supply determines the division between the two. For example suppose we have sticky nominal wages, with W depending on W* (what workers expected W to be, based on recent trends in nominal wages) and N (as employment gets closer to full employment, workers start to expect higher wages). We could have N affect the shape as well as the level of supply curve. That is, the effect of a change in N on wages could be low in a recession and higher near full employment.

From the Fred database, I have downloaded total compensation from the national income accounts (WN, in effect). And I downloaded total payroll employment from the establishment survey (N, in effect). The ratio of the two gives W. Some recent data on the percent change of these numbers.

Year WN percent change W percent change
2008 2.3 2.9
2009 -3.6 0.8
2010 2.3 3.1
2011 3.9 2.7
2012 4.0 2.3

Over the last five years, the median value for the percent change in nominal compensation has been only 2.3 percent. during the entire Great Moderation (1986-2007), there was only one year where nominal compensation grew by less than 2.3 percent (it was 1.6 percent in 2002). The median during the Great Moderation was 5.2 percent. Using this as a measure of aggregate demand shows weakness. Of course, any product involving N would show weakness, so don’t get too excited, folks.

The Phillips-Curve half of the story does not go as smoothly. Perhaps the 2009-2010 pattern is a fluke, and you should just average those two numbers? In any event, we had higher wage growth throughout most of the Great Moderation, but not all of it. From 1993-1996, annual wage growth was 2.1 percent, 1.8 percent, 2.1 percent, and 3.1 percent, respectively. What caused that episode of sluggish wage growth? In that case, it was not weak aggregate demand.

Land Price Appreciation and Consumption

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David Altig writes,

why should there be a “wealth effect” at all? If the price of my house falls and I suffer a capital loss, I do in fact feel less wealthy. But all potential buyers of my house just gained the opportunity to obtain my house at a lower price. For them, the implied wealth gain is the same as my loss. If buyers and sellers essentially behave the same way, why should there be a large impact on consumption?

This was the crux of his blog post, although he later crossed it out because a colleague suggested it was oversimplified. Pointer from Mark Thoma.

Some comments:

1. When land prices rise, we are looking for asymmetries between the behavior of the winners from higher land prices (home owners) and the losers from higher land prices (non-owners). Conversely, when land prices fall, the winners are non-owners and the losers are owners. If the winners and losers behave symmetrically, then the effect on overall consumption should not be large.

2. As Altig points out, it could be that access to credit behaves asymmetrically. Owners experience large swings in access to credit to finance consumption via home-equity extractions, while non-owners do not experience such swings.

3. There may be a Shillerian channel, based on expectations of house price changes. That is, the effect of past changes in house prices is symmetric. However, as prices rise, owners tend to be people with high expectations for future price increases. They expect their wealth to rise, and they spend some of these anticipated gains. If non-owners had similar expectations of rising land prices and were symmetrically concerned about future increases in their living costs as a result, then they would save more. But they are not symmetrically concerned.

4. If we get out of the AS-AD framework and into the PSST framework, a broad-based land-price bubble might be less distorting than an uneven land-price bubble. A broad-based bubble creates too many real estate agents, mortgage loan officers, and homebuilders. An uneven bubble causes all sorts of ancillary businesses to locate differently. Entrepreneurs open restaurants and high-end shopping centers in booming areas*, and then when the bubble bursts they are stuck with bad investments.

*But why are they not closing such businesses in lagging areas?

Ideology and Macroeconomics

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Scott Sumner writes,

I am amazed by how many proponents of fiscal policy don’t understand that it’s symmetrical. Fiscal policy doesn’t mean more government; it means more government during recessions and less government during booms, with no overall change in the average level of government. Anyone who doesn’t even get to that level of understanding, who doesn’t think in terms of policy regimes, is simply not part of the serious conversation.

I agree with the first two sentences, but not with the last.

Yes, in theory, there should be economists who, as they argued for more stimulus in 2009, should at the same time have been arguing for entitlement reform or other reductions in future spending. Other things equal, the bigger debt that we have accumulated over the past five years would make a non-ideological macroeconomist want to propose tighter fiscal policy somewhere down the road.

But “nonideological” and macroeconomics are nearly oxymorons. Name a prominent economist who believes that fiscal expansion is important during recessions and who also is to the right of the median economist on issues like school choice or taxing the rich or the usefulness of regulation. Or try to name a prominent economist who is to the left of the median economist on those issues and who does not believe that fiscal expansion is important.

I know that I was more to the left generally 30 years ago, and I was a confirmed Keynesian. I am more to the right today, and I am a skeptic of Keynesianism.

I do not think that being on the left (right) on other issues necessarily causes you to be a supporter (skeptic) of Keynesianism. However, I do think that people try to avoid affiliative dissonance and cognitive dissonance.

Cognitive dissonance is an issue because if your general view is that market failures are small and difficult for government to correct, then it is hard to fit Keynesianism in with that belief. If your general view is that market failures are significant and require government intervention, then it is hard to fit the skepticism toward Keynesianism in with that belief.

Affiliative dissonance is my own expression. It just means that if the people with whom you feel an affinity on issues W, X, and Y take a position on issue Z with which you disagree, that makes you uncomfortable. Other things equal, this will make it easier to get you to change your mind on issue Z.

We know from Daniel Kahneman (and others) that we are good at rationalizing opinions that may be arrived at on the basis of intuition. I am not saying that therefore we will never find truth in macroeconomics. What I am saying is that if you close your ears every time you detect someone’s ideology embedded in what they say about macroeconomics, then you will not hear anything.

Two Types of Confidence

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Watch this video of Robert Shiller from a few years ago.

Source here. Pointer from Tyler Cowen.

Shiller’s body language, speaking style, and content suggest discomfort. He is like a kid (and of course he has very boyish looks for someone in his 60s) talking about why he never gets picked by the other kids to play in team games at recess.

And yet, when I showed the video to my students, one of them reacted by saying that Shiller seemed arrogant. And I think there is something to that, as well.

Contrast the confidence of Stanley Fischer, the voice of authority. Fischer knows that when he speaks, respectable macroeconomists stand with him. Over the years, he had make-or-break power over the careers of most of them.

Shiller has a different type of confidence. His is the confidence of the boy who sees the naked emperor. He has found what he is pretty sure are fundamental flaws with the mainstream world view.

So, there is establishment confidence. That is the confidence that you have the establishment with you, agreeing with your world view and respecting your power. Then there is outsider confidence, the confidence that you have in your ideas and a belief that it is better to be a low-status person with good ideas than a high-status person with mainstream ideas that are not as good.

It is easy for me to see Timothy Geithner not wanting to have Shiller in the room. Geithner has establishment confidence, which is threatened by outsider confidence.

Having said that, I myself am not heavily influenced by Shiller’s ideas. In finance, I like Frydman and Goldberg’s critique of rational-expectations modeling. In particular, different people are bound to have different information and different models. In macro, I am inclined toward a Schumpeterian story of difficult adjustment to changes in productivity in different sectors. However, if you want tell an aggregate-demand story, then I am with Shiller that “animal spirits” sounds like a better place to start than the Euler equation of a single representative consumer/worker.

Money Illusion in Wage Behavior: How Important?

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Simon Wren-Lewis writes,

My second complaint is that the microfoundations used by macroeconomists is so out of date. Behavioural economics just does not get a look in. A good and very important example comes from the reluctance of firms to cut nominal wages. There is overwhelming empirical evidence for this phenomenon (see for example here (HT Timothy Taylor) or the work of Jennifer Smith at Warwick). The behavioural reasons for this are explored in detail in this book by Truman Bewley, which Bryan Caplan discusses here. Both money illusion and the importance of workforce morale are now well accepted ideas in behavioural economics.

Read his whole post. The paragraph I quoted includes links that I did not transfer here. Pointer from Mark Thoma.

Some comments:

1. Just because something can be shown to exist at the micro level does not mean that it is important at the macro level. (This is in some ways equivalent to the point that just because you have what you think makes a neat microfoundation does not mean that it helps you with macro.)

2. In particular, if worker A at firm X suffers from money illusion, that does not imply that macroeconomic behavior will look like that worker and firm. There is plenty of exit and entry among firms as well as turnover in the labor force.

3. Indeed, I happen to agree with Robert Solow that what makes the DSGE framework so unpromising is that it typically insists on modeling a single consumer/worker/capitalist as representative of the entire economy. Obviously, you tend to forget about entry and exit and labor force turnover when you do that.

4. When one looks at macroeconomic data for evidence of money illusion, the results seem to me to be decidedly mixed.

a. Matt Rognlie writes,

A large output gap is extraordinarily effective at bringing inflation down from, say, 8% to 2%, but far less effective at bringing about a drop from 2% to -2%.

If that is true, then it looks like a point in favor of money illusion. To believe that it is true, you have to believe in the original Phillips Curve. That’s easy to do if your macroeconomic thinking was shaped by the 1960’s. Maybe it’s easy to do if your thinking was shaped by the last five years, although in that case you have only observed one region of the Phillips Curve. Looking at other time periods raises doubts.

b. If you put your chips on nominal wage stickiness to explain recessions, then I do not see how you avoid predicting a countercyclical share of labor income in GDP. That prediction is strongly violated by a number of downturns, including the current one.

c. Also, if you put your chips on nominal wage stickiness, youth unemployment should be relatively low in a recession. People who are just entering the job market are not comparing current job offers to previous salaries.

d. If there is money illusion, probably there are other illusions that allow employers to adjust at the margin without being able to reduce wages. As an employer, I can put more work on your desk. I can reduce bonus payouts. I can require a longer vesting period for stock options or pension benefits. I can reduce the match on your 401(K). I can increase what you have to contribute to health insurance. There seem to be enough margins available that sticky nominal wages should not matter.

5. On balance, I think that the case for wage stickiness as a crucial macroeconomic phenomenon is quite flimsy, notwithstanding the strong case for nominal wage stickiness that can be made by looking at micro behavior.