Category Archives: PSST and Macro

Monetary Offset

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See Scott Sumner’s short paper.

estimates of fiscal multipliers become little more than forecasts of central bank incompetence. If the Fed is doing its job, then it will offset fiscal policy shocks and keep nominal spending growing at the desired level. Ben Bernanke would deny engaging in explicit monetary offset, as the term seems to imply something close to sabotage. But what if he were asked, “Mr. Bernanke, will the Fed do what it can to prevent fiscal austerity from leading to mass unemployment?” Would he answer “no”?

The Keynesian point of view is that the Fed “ran out of ammunition” when the Fed Funds rate went to zero. At this point, I do not know what to say to people who take that view. If it were true, then the fiscal multiplier should be bigger than one would otherwise expect. Yet it seems to have turned out smaller–the stimulus did less than predicted, and the austerity did less damage than predicted. And to me, it seems obvious that as long as there is stuff that the Fed can buy, including long-term bonds and foreign currency, it has “ammunition.” But the Keynesians routinely dismiss as incompetent anyone who who claims that the Fed cannot run out of ammunition. Perhaps Scott’s paper will force them to actually defend their position, although chances are that they will just continue to ignore or insult those with whom they disagree.

My own views do not align with either Sumner or the Keynesians. PSST is an alternative to the AS-AD story.

Revisiting the Great Stagflation

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Karl Smith writes,

I tend to think far little attention has been paid to the rapid increase in the work force due to the entrance of baby boomers and women. Economists are so sensitive to any argument against immigration they seem to forget that any growth model that I am aware of will predict a decline in per capita GDP if the population rises fast enough.

He cites a 1999 paper by Athanasios Orphanides, who wriote,

I examine the evolution of estimates of potential output and resulting assessments of the output gap during the 1960s and 1970s. My analysis suggests that the resulting measurement problems could be attributed in large
part to changes in the trend growth of productivity in the economy which, though clearly seen in the data with the benefi t of hindsight, was virtually impossible to ascertain in real-time.

I am glad to see folks renewing their interest in the Great Stagflation. I certainly spend a lot of time on it in the book that I am working on. In my case, I am particularly interested in the human dimension of how it affected economists. There was much more professional turmoil back then. For example, consider how quickly the great economists of the 1960s went from the center of the profession to its periphery. In 1968, if you had held a session at the AEA meetings featuring Walter Heller, Arthur Okun, Lawrence Klein, and Otto Eckstein, you would have needed a ballroom to accomodate everyone who wanted to attend. In 1974, you could have held it in a suite.

Contrast that with the impact of the Great Recession. Who were the big names before it hit? Blanchard, Woodford,, Bernanke, Gali. Who are the big names now? Same ones.

So in the 1970s, unexpected macroeconomic events create a dinosaur extinction. Today, nothing. Explain that to me.

Concerning the point raised by Karl Smith and Steve Waldman, as best I recall, economists back then were making adjustments for changes in the composition of the work force in their calculations of trend productivity growth. That was part of the story for poor economic performance, but not all of it. Some points to consider.

1. As I posted a while back, Alan Blinder thinks that much can be accounted for by a series of supply shocks–from oil price increases to Peruvian anchovy disappearances. I would add that I think that price controls were a self-inflicted supply shock, particularly in the oil market. At the time, many economists (Blinder among them) wrongly thought that price controls were a favorable supply shock. But I think that by messing up market adjustments they were an adverse shock.

2. I think that there was a lot of money illusion in financial markets in the 1970s. That is, people looked at high nominal interest rates and treated them as high real interest rates. Thus, as Modigliani and Cohn (you can Google Modigliani Cohn 1979) pointed out, the stock market seemed to be discounting real earnings at nominal rates. But the main problem was that real rates remained very negative. In my view, this was the fault of the private sector, although I think there was money illusion at the Fed as well. But in my view, regardless of what the Fed was doing with short-term rates, nobody was forcing long-term bond investors to take negative real rates. Yet that is what they did.

So the story I would tell is that the high inflation came from these negative real interest rates, and perhaps from the series of supply shocks Blinder discusses. The high unemployment came from the energy shock, exacerbated by the self-inflicted disruption of price controls.

What Would Keynes Have Done?

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Bradley Bateman writes,

He never said that the government could exactly hit some target. This is an idea that came from one of the first great Keynesian texts published in the late 1940s, Functional Finance by Abba Lerner

Bateman writes in a collection of essays called The Economic Crisis in Retrospect, which tries to ask what great economists of the past might have said about the financial crisis of 2008. It is published by Edward Elgar, which typically prices its products for libraries as opposed to the mass public. I was sent a review copy.

Bateman also claims that Keynes did not believe in running government budget deficits. “In many ways he was Libertarian.” Of course, he was always in favor of public works as a stimulus package, but Bateman claims that Keynes proposed using the government’s sinking fund to finance this. It is not clear to me why this is not deficit spending.

In another essay, on Joseph Schumpeter, Richard N. Langlois quotes from Capitalism, Socialism, and Democracy.

Capitalism, then, is by nature a form or method of economic change and not only never is but never can be stationary. And this evolutionary character of the capitalist process is not merely due to the…social and natural environment…The fundamental impulse that sets and keeps the capitalist engine in motion comes from new consumers’ goods, the new methods of production or transportation, the new markets, the new forms of industrial organization that capitalist enterprise creates.

Langlois says that Schumpeter explained the business cycle by saying that it takes a while for signals of obsolescence to reach the firms that are affected. Langlois writes,

They do not stop making carbon paper right away. So there is an economic boom that starts as the new technology spreads. It creates what Schumpeter calls a secondary boom that is artificial. Because what should be happening is that resources should be being withdrawn from carbon paper at the same time they are being put into computers. But that does not happen. The carbon paper is still there because those signals have not yet reached those who finance carbon paper. Yet there is a boom in computers. The whole process is not sustainable.

The book has other interesting essays including one by Perry Mehrling, who gives his view that we need to extend government protection to shadow banking, as well as one by Thomas Sargent, who raises some doubts about that approach.

Although I found the book worth reading, and I may re-read Sargent’s essay (I found a video of Sargent delivering his essay, and I passed it along to Scott Sumner, who seems to have had as much difficulty as I did following it.), I would not put it at the top of your wish list.

Tyler Cowen on the Tobin Model

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Tyler Cowen writes,

Another option is that these non-stifled sectors have seen big boosts in demand and thus their prices are rising. Again, that violates the strong empirical regularity of business cycle comovement. In a traditional deflationary downturn, virtually all sectors are negatively affected, with a few notable exceptions. What kind of business cycle would this be, if half the economy is seeing a positive 3.2% worth of demand-side pressures?

In “Inflation and Unemployment,” James Tobin (1971) proposed that there might be two sectors of the economy, one with demand expanding and the other with demand contracting. If prices and wages were flexible, then you could reach full employment at any rate of inflation. However, if nominal wages will not fall in the contracting sector, then you get a trade-off between inflation and unemployment.

What Tyler is arguing is that if this model were applicable in reality, then we would observe recessions as sharp contractions in some sectors while other sectors continue to expand. Instead, he suggests that declines are broad-based. Of course, many people claim that if many sectors are declining at once, then we must be experiencing a decline in aggregate demand, as opposed to structural unemployment.

My thoughts:

1. Has the shortfall in employment been widespread or concentrated? I think that if one looks across industries, it seems fairly widespread. Yes, health care has held its own. Yes manufacturing has taken a large share of the job losses. But overall, things look widespread.

2. However, if one looks at demographics, I think it looks more concentrated. Older workers have held their own (and moreso, relative to the previous trend). Young people are being devastated.

3. What would a central planner (or a ruthless free market) do with average young people in an “average is over” world? (I have not yet read Average is Over, but let me steal the phrase.) I think that the solution would be to have many young people become personal servants, taking care of old people or rich people. However, this is not something that young people want to do. It is not what their parents, teachers, and political leaders are telling them to do. Instead, our society has arrived at a tacit agreement that is it is preferable for young people to live off of a combination of government benefits and parental support.

4. This “tacit agreement” would hold at any rate of inflation. If we managed to raise the rate of inflation, I do not think it would do much to deal with unemployment.

David Andolfatto’s Challenge

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He writes,

The PCE inflation rate since 1990 averaged 2.09% per annum.

What’s interesting about this diagram is that even though the Fed does not officially target the PCE price level, the data above suggests that the Fed is behaving as if it does.

As a price-level (PL) target is equivalent to a nominal GDP (NGDP) target in a wide class of macroeconomic models (especially under the assumption of constant productivity growth), then what more does the NGDP crowd expect from an official NGDP target? Seems to me that they are just asking for more price inflation and wishfully hoping that some of the subsequent rise in NGDP will take the form of real income.

Tell me I’m wrong (and why).

Pointer from Mark Thoma.

1. I made a similar point when I wrote,

From April of 2003 through April of 2008, the rate of growth of the CPI averaged 3.2 percent. From April of 2008 through April of 2013, it averaged 1.6 percent. If in 2007 you had asked macroeconomists to predict the consequences of a decline in the inflation rate of that magnitude, how many would have told you to expect unemployment to rise above 7 percent? None of them would have foreseen it. My guess is that many of the macroeconomists would have regarded a drop in inflation of 1.6 percentage points as close to a non-event for unemployment.

2. I downloaded the quarterly PCE data from 1990 Q1 through 2013 Q3. The average inflation rate (simple average, not compounded) was 2.16 percent for the whole period. For the sub-period prior to 2008 Q3 it was 2.34 percent. For the sub-period since it has been 1.43 percent. So, suppose the Fed’s inflation target was actually 2.34 percent. In that case, it recently undershot its target by 0.91 percentage points. As I pointed out above, that hardly seems like enough to cause Armageddon.

In fact, it was not even the worst miss. From 1997 Q3 through 1999 Q3, the PCE inflation rate averaged 1.10 percent, which would be a miss of 1.20 percentage points. If 0.91 caused the Great Recession, why was 1.20 consistent with strong growth?

3. One of Scott Sumner’s arguments against targeting prices is that prices are mis-measured. I think if you go with the mis-measurement argument, you have to explain away the 1997-1999 anomaly by saying that there was more inflation and less real growth than what the statisticians reported; turning to 2008-Q3 to present, you explain the anomaly by saying that there was less inflation and more real growth than what the statisticians reported. I think those are pretty difficult cases to make. The sorry-looking employment figures for the last five years are consistent with weak real growth. (NOTE: I wrote this before Scott Sumner replied, but I think I anticipated most of Scott’s points. These days, I almost never publish a post immediately. Scheduling them in advance instead makes me more careful.)

4. I hope that Andolfatto sees that there is a larger point to be made here than to pick on Scott Sumner. If a “wide class” of models suggests that you would not see a Great Recession arising from a small miss to an inflation or price-level target, then I think it is time to open one’s mind to other ideas.

(The term “wide class” sticks in my craw. In my table of contents, you may recall that I said “the macroeconomics profession became narrow, inbred, and retarded.” The book is progressing well, but I have left that phrase out for now.)

Robert Gordon on the Phillips Curve

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He writes (can anyone find a free, ungated copy?),

The implied short-run unemployment NAIRU is highly stable, staying in the range of 3.9 to 4.4 percent between 1996 and 2013. However, the rise in the extent and duration of long-run employment causes the NAIRU for the total unemployment rate (short-run plus long-run) to increase from 4.8 percent in 2006 to 6.5 percent in 2013:Q1. As a result, this paper supports the recent research that argues that there has been an increase in structural unemployment taking the form of long-run unemployed.

Gordon talks up what he calls the “triangle” approach to the Phillips Curve, as opposed to the New Keynesian approach (NKPC).

The triangle approach differs from the NKPC approach by including long lags on the dependent variable, additional lags on the unemployment gap, and explicit variables to represent the supply shocks…the change in the relative price of non-food non-oil imports, the eight-quarter change in the trend rate of productivity growth, and dummy variables for the effect of the 1971-74 Nixon-era price controls.

This methodology is so reminiscent of the 1970s that it makes me want to wear bell-bottom jeans and listen to disco.

No inflation model has any credibility unless it deals explicitly with the supply shocks that created the positive inflation-unemployment correlation in the 1970s and early 1980s and the lead of inflation ahead of unemployment. But this was not the only episode. Between 1996 and 2000 the unemployment rate descended far below its 5.84 average to less than 4.0 percent, and yet the inflation rate did not speed up as it had done in the late 1960s and late 1980s. The triangle model explains why inflation was so tame, pointing to beneficial supply shocks during the late 1990s – oil prices were low, the dollar was appreciating, and productivity growth was reviving.

He points out that a simple plot of the Phillips relation between 1970 and 2006 looks simply awful (from the point of view of anyone who thought that the 1960s Phillips Curve would persist).

The overall correlation appears to be positive but very weak, close to zero, and the 1970-80 observations in the scatter plot once led Arthur Okun to describe the PC as “an unidentified flying object.”

Gordon’s productivity trend acceleration variable is really important.

Its deceleration into negative territory during 1964-1980 might be as important a cause of accelerating inflation in that period as its post-1995 acceleration was a cause of low inflation in the late 1990s. Note also that the productivity growth trend revival of 1980-85 may have contributed to the success of the “Volcker disinflation,” a link that has been missed in most of the past PC literature. There has been a sharp deceleration of trend productivity growth since 2004, helping to explain the absence of deflation in the past few years.

Note that there are other ways to arrive at a negative correlation between productivity growth and inflation. You could have measurement error in the rate of inflation (if you overstate price increases, you understate productivity growth, and conversely). You could have the Fed following a policy that approximately targets nominal GDP, so that when productivity goes up inflation goes down, and conversely.

From a modern perspective (meaning any graduate macro syllabus after 1975), the “triangle” model is hard to swallow. In Gordon’s model, the only way for money to affect inflation is through the “output gap.” My guess is that this makes hyperinflation a mathematical impossibility in the Gordon model–to get to 100 percent inflation rates would probably require decades of a negative output gap, which is not what preceded any of the many actual hyperinflations in the world.

For me, the important point is to keep in mind is that there is no unique interpretation of the path of nominal GDP, employment, productivity, and inflation. Take any three of those as given, and you arrive at the fourth. Arithmetically,

[1] growth in nominal GDP minus growth in inflation = growth in employment plus growth in productivity

Scott Sumner says “tell me the path of nominal GDP, and I will tell you the path of employment.” He is bound to be right, as long as you do not have to worry about how inflation and productivity move in the short run. And they will move in opposite directions to the extent that inflation is measured with error.

Robert Gordon says “tell me productivity growth and the rate of short-term unemployment, and I will tell you the rate of inflation.” He is bound to be right about productivity growth, since if we hold nominal GDP growth and employment constant, productivity growth and inflation vary inversely. His problem is that, arithmetically, employment and inflation should be negatively related. But if you eliminate all instances of positive relationships between unemployment and inflation by calling them “supply shocks” (which differ from time-varying productivity), then by golly, the Phillips Curve is indeed “alive and well.”

I say that in order to claim to have a macroeconomic model, you have to treat nominal GDP, employment, inflation, and variations in trend productivity all as endogenous. Otherwise, you are just choosing one interpretation from among many.

The Great Stagflation Revisited

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Alan s. Blinder and Jeremy B. Rudd write,

This paper reexamines the impacts of the supply shocks of the 1970s in the light of the new data, new events, new theories, and new econometric studies that have accumulated over the past quarter century. We find that the classic supply-shock explanation holds up very well; in particular, neither data revisions nor updated econometric estimates substantially change the evaluations of the 1972-1983 period that were made 25 years (or more) ago. We also rebut several variants of the claim that monetary policy, rather than supply shocks, was really to blame for the inflation spikes.

In his 1967 AEA Presidential address (published in 1968), Milton Friedman predicted the death of the Phillips Curve. When this prediction apparently came true a few years later, most of the profession shifted toward the view that inflation is a monetary phenomenon. A few economists remained unconvinced, and Blinder appears to be one of them. Blinder has always blamed the high inflation of the 1970s on rising food and energy prices and the removal of the wage-price controls of 1971-73. He and his co-author write,

a permanent increase in the level of energy prices should cause a quick burst of inflation which mostly, but not quite (because of pass-through to the core), disappears of its own accord. Once again, headline inflation quickly converges to core, but now core inflation remains persistently higher than it was before the shock.

This sentence would horrify anyone who took macro at MIT when I was there, by which point there was a monetarist influence, coming from Dornbusch and Fischer. Blinder is saying that a one-shot increase in the relative price of oil will cause a permanent increase in the rate of inflation. And he is ignoring the money supply. As an aside, he seems to be casually equating a the level of prices with the rate of change of prices.

I actually admire this willingness to go against prevailing fashion. Moreover, he may be right. It is an article of faith among economists that the 1970s inflation and the 1980s disinflation both came from monetary policy, but that does not make it a proven fact. Maybe we have too much faith. Instead, we should be willing to examine data and adopt a skeptical perspective.

In any case, this is a must-read paper for anyone interested in macroeconomic history. It reminds us of the “food shocks” that took place. It reminds us that the CPI used to include the mortgage interest rate. It reminds us that

the main effect of the OPEC I production cuts, which were neither exceptionally large nor long-lasting, was to create significant uncertainties about oil supply, which induced a surge in precautionary demand for oil.

In fact, I wonder if the first oil shock might have been more U.S.-based than OPEC-based. The Democratic Congress and Presidents Nixon and Ford were obsessed with trying to keep consumer energy prices and oil company profits down. They concocted a Byzantine scheme of price controls, oil allocation, and “windfall profits” taxes. The technocrats spoke of “old oil” (oil that had been discovered in the U.S. prior to the fall of 1973) “new oil” (oil discovered since that date), and “imported oil.” Their goal was to try to make the energy market work as if oil companies were selling “old oil” at pre-1973 prices. Perhaps it was these attempts to centrally administer oil production that were the real supply shock.

The authors continue,

Similarly, the rise in prices associated with the second OPEC shock appears to have been driven more by fear of future shortages than by actual reductions in supply.

Or perhaps the oil industry anticipated another round of byzantine regulation and punitive taxes. Recall that instead, when President Reagan took office in 1981, one of his first acts was to get rid of the remaining price controls in the energy market.

Blinder comments on the puzzle that subsequent energy price shocks had less effect on both inflation and unemployment. He cites a number of possible explanations: a less energy-intensive economy; more flexible wages; more public confidence that the Fed will hold down inflation. I think that the answer might be less attempts to regulate prices and profits in the domestic oil market.

Labor Force (non-) Participation

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David Leonhardt writes,

Yes, the unemployment rate has fallen. But almost the entire reason it has fallen is the drop in the number of people in the labor force — either working or actively looking…This shift long predates the recent financial crisis, too. The labor force participation rate peaked more than a decade ago… the labor force participation rate has fallen almost as sharply for people aged 25 to 54 as it has for the overall adult population.

Pointer from Mark Thoma.

Leonhardt refers to this white paper, from Express Employment Professionals, which appears to be a search firm. It says,

According to Gallup’s “Payroll to Population” measure, fewer Millennials were working full time in June of 2013 than in June of 2012, 2011, or 2010…

That paper and Leonhardt also refer to a note by San Francisco Fed economists Leila Bengali, Mary Daly, and Rob Valletta. They write,

Although the 2007–09 downturn exhibits a strong positive relationship between state-level changes in employment and participation, the recovery so far does not. This calls into question our interpretation that much of the recent participation decline is cyclical and likely to reverse. However, the current weak correlation between changes in employment and labor force participation could reflect employment’s relatively modest recovery to date. The economy has been expanding for a sustained period. But, as of March 2013, we have recovered only 67% of total jobs lost during the downturn. Thirty-seven months after the employment trough in past recoveries, employment greatly exceeded the pre-recession peak.

Leonhardt argues that the phenomenon of lower labor force participation is important. I agree.

It is hard to invoke conventional macroeconomics to explain it. Sticky nominal wages? If wages are too high, then I would think we should see labor force participation that is high rather than low. That is, lots of people would want to work because wages are too high to clear the labor market.

Casey Mulligan’s idea of a redistribution recession? As I read the recent Cato paper by Tanner and Hughes, since 1995 the disincentive to work has gone down in many states (see table 2 of their paper). For example, in Illinois, they calculate that in 1995 overall welfare benefits were a salary equivalent to $29,000, but today they are only $13,580, after adjusting for inflation. One would think that labor force participation would have increased in such states. Meanwhile, no large state shows an increase of as much as $5000. I think one would have to bring disability into the story to make the case. Indeed, the white paper from EEP says,

Fourteen million Americans, including roughly 8.5 million former workers receive disability. In 2011, that included 4.6 percent of the population between the ages of 18 and 64. These Americans are not included among the “unemployed.” And it’s estimated that less than one percent of them have returned to the workforce in the last two years.

Another story to invoke is that of job polarization. The EEP paper refers to a previous survey.

The survey also found that 53 percent of more than 400 U.S. employers say that recruiting and filling positions is “somewhat difficult” or “very difficult.”

Macroeconomic Methodology

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Here is the draft introduction and conclusion to my chapter on economics as history rather than physics.

Economists love to dress up as physicists. We like to put theories into the form of equations. However, there are important differences between physics and economics, and these differences are particularly pronounced in the case of macreconomics…

1. Politicians and journalists want answers to questions such as, “How many jobs will (or did) a certain stimulus proposal create?” However, it is not possible to give reliable answers to such questions. Economists who purport to do so are misrepresenting the state of knowledge that actually exists.

2. Economists would like to know which theories are ruled out by the data and which theories are supported by the data. However, our ability to make statements along these lines is quite limited.

3. I believe that the study of macroeconomic events is going to have to be comparable to the study of revolutions, wars, or other historical events. There will be many plausible causal factors per event.

4. It will not necessarily be the case that the best explanations for macroeconomic events will be a single “model” that uses the same causal factors for every event. Instead, each important macroeconomic event may have important idiosyncratic elements involved.

5. Many very different explanations for an event will be consistent with the data.

6. Neither the use nor non-use of equations will ensure clarity or logical consistency. Confusion may be embedded in verbal descriptions of macroeconomic theories. Confusion also may be embedded in equations.

7. Neither verbal descriptions nor equations express verifiable relationships. Macroeconomic hypotheses will contain assumptions that will be highly contestable.

Noah Smith Picks Up the Theme

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He writes,

In macro, most of the equations that went into the model seemed to just be assumed. In physics, each equation could be – and presumably had been – tested and verified as holding more-or-less true in the real world. In macro, no one knew if real-world budget constraints really were the things we wrote down. Or the production function. No one knew if this “utility” we assumed people maximized corresponded to what people really maximize in real life. We just assumed a bunch of equations and wrote them down. Then we threw them all together, got some kind of answer or result, and compared the result to some subset of real-world stuff that we had decided we were going to “explain”. Often, that comparison was desultory or token, as in the case of “moment matching”.

In other words, the math was no longer real. It was all made up. You could no longer trust the textbook. When the textbook told you that “Households maximize the expected value of their discounted lifetime utility of consumption”, that was not a Newton’s Law that had been proven approximately true with centuries of physics experiments. It was not even a game theory solution concept that had been proven approximately sometimes true with decades of economics experiments. Instead, it was just some random thing that someone made up and wrote down because A) it was tractable to work with, and B) it sounded plausible enough so that most other economists who looked at it tended not to make too much of a fuss.

I think that this is a well-expressed criticism, which Paul Krugman sidesteps in his response. I understand Krugman’s point to be that it is possible when expressing ideas verbally to say something that would be incoherent or self-contradictory if you were to try to express it in mathematical terms.

However, let us reflect on Smith’s point. Macroeconomic equations are not proven and tested. They are instead tentative and speculative. And macroeconomists have not been able to avoid allowing math to disguise this tentative, speculative quality of theory. Indeed, in the very same post in which Krugman defends math, he writes,

The basics of what happens at the zero lower bound aren’t complicated, but people who haven’t worked through small mathematical models — of both the IS-LM and New Keynesian type — generally get all tied up in verbal and conceptual knots.

In fact, it is pretty to easy to understand the liquidity-trap argument without mathematical models. However, the idea embedded in IS-LM models that there is only one interest rate is controversial (in fact, it is downright false). The idea that the Federal Reserve runs out of things to buy when the Fed Funds rate is zero is controversial. The idea that an interest rate that is “close to zero” is the same as an interest rate that is zero is controversial. Yet Krugman appears to be so persuaded by his math that he cannot seem to come to terms with anyone who disagrees with his view that the liquidity trap is an important characterization of the current U.S. economy.

I think that Noah Smith has expressed clearly and profoundly that macroeconomists who dress up like physicists are being tragically foolish. I think it is one of the best blog posts that I have ever read.

The idea of freeing macro from its pseudo-physics pretensions came up in Jag Bhalla’s post that I mentioned the other day. Perhaps it is something “in the air” right now. I hope so.