Category Archives: PSST and Macro

Rules vs. Discretion

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Scott Sumner writes,

I’m all for a rules-based approach to policy. But unfortunately Taylor fails to make his case. You’d think a fan of rules-based policy would provide a razor sharp critique of Fed policy, but Taylor’s critique is anything but clear

Scott Sumner’s rallying cry is “Target the Forecast!” (for nominal GDP) and John Taylor’s rallying cry is “Follow the Taylor Rule!”

Some remarks:

1. I think I saw the clash between Sumner and Taylor coming even before Sumner did.

2. “Target the Forecast!” is, in a generic sense, what the Fed has been doing since the 1960s. The FOMC discussions revolve around forecasts. Fed staff scrutinize data closely in order to divine what it means for the forecast. Alan Greenspan was an intense and promiscuous data-scrutinizer. Taylor would argue that, until late in his term, Greenspan’s target-the-forecast approach happened to line up with the Taylor rule.

3. What is the result? As Ed Leamer puts it in chapter 15 of Macroeconomic Patterns and Stories,

On the basis of circumstantial evidence, the Federal Reserve Board, by raising rates late in expansions, can take some blame for almost all our recessions.

Below is circumstantial evidence of the sort he describes. See how large moves in the Fed Funds rate tend to lead large moves in the unemployment rate.

4. Leamer also says,

With all these patterns, it is a mystery* whether monetary policy can be said to cause anything or merely reacts to things that would have occurred anyway. But if I felt the need, I could suppress the doubt and tell with confidence the following story.

[Expansions start out with mild inflation. Then price pressures build as the expansion matures] But the Fed fiddles as inflation smolders. The ever-so-gradual increase in inflation is not enough to get the Fed to respond, but like a small brush fire, inflation soon enough gets out of control…By the time the data are in, and the Fed rate-setting committee has deliberated enough to make absolutely sure that it is time to make a change in monetary policy, inflation is burning fiercely and it takes a heavy spray of higher interest rates to put the fire out. That creates an inverted yield curve, a credit crunch** for housing, and an unpleasant recession. Oh, Oh, we’re sorry, say the Fed Governors, who knock down interest rates to try to get housing and the rest of the economy back on their feet.

5. From this historical perspective “target the forecast” is what got us where we are today. Sure, it looks like a great idea now, when we think that the expansion is still not mature and price pressures are still nowhere to be seen. But eventually “target the forecast” will once again result in a failure to change policy in time. We will continue to experience needless, Fed-induced cyclical behavior unless the Fed is lashed to a rule.

6. You might characterize my beliefs as:

Probability that “target the forecast” (using some market prediction for nominal GDP) would stabilize the economy = .15

Probability that “stick to a rule” would stabilize the economy = .10

Probability that monetary policy “merely reacts to what would have occurred anyway” = .75

*The “mystery” arises in part because the Fed only controls the short-term nominal interest rate, and it is the long-term real interest rate that most plausibly drives spending. In chapter 5, Leamer writes,

the interest-rate on the 10-year has a life of its own, sometimes moving with the 3-month rate, but not always. That should make one wonder how much impact the Fed has on the longer-term rates and also wonder how much it matters.

In chapter 15 he says that

long-term interest rates were generally elevating at the ends [of economic expansions since 1960]. Maybe that is what killed off housing. Maybe that would have occurred even if the Fed had not taken action.

**Leamer was writing prior to 2008, when a different sort of credit crunch arose. I will discuss the Leamer credit-crunch model in a subsequent post.

What Does Japan Exemplify?

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Noah Smith writes,

It seems to me that the standard New Keynesian sticky-price story just cannot explain Japan. The “short run” for Japan is over and done. We are not looking at a “short-run” fluctuation caused by sticky prices.

Pointer from Tyler Cowen.

In textbook terms, Smith is saying that the long-run aggregate supply curve is vertical, so aggregate demand does not matter.

Paul Krugman objects. In textbook terms, Krugman is saying (I am pretty sure) that in a liquidity trap the aggregate demand curve is vertical, so that the long-run aggregate supply curve does not matter.

So it gets back to whether one believes in a liquidity trap. Krugman writes,

the only reason deflation “works” in the standard model is that it increases the real money supply, which leads to lower interest rates; in effect, it acts like an expansionary monetary policy.

It depends what you mean by standard model. Some economists would put the Pigou Effect into the standard model. Krugman can argue–and has argued–that the Pigou Effect does not apply in Japan. Anyway, I personally don’t stake my case against the liquidity trap on the Pigou effect.

But the standard model actually has another channel by which lower prices raise demand, imparting a downward slope to the aggregate demand curve. It comes from the trade balance. If wages and prices go down in Japan, and this is not offset by an appreciation of the yen, then Japanese goods become cheaper in America and American goods become more expensive in Japan. As a result, the demand for Japanese output goes up. If Krugman has an argument that refutes this, I would like to see it.

Not surprisingly, Scott Sumner has a take.

The BOJ has produced 20 years worth of adverse AD shocks. In both 2000 and 2006 they raised interest rates despite the fact that Japan was experiencing deflation. In 2006 they cut the monetary base by 20%.

So, it’s a sequence of aggregate demand curve shifts. If the Bank of Japan would just hold still for a sec, the economy would find its way back to the long-run aggregate supply curve. As usual, Sumner is coherent, but I am not persuaded.

Smith continues,

But I don’t think Japan is living in an RBC world either. Because in an RBC world, keeping interest rates at zero for decades, and printing a bunch of money (as the Bank of Japan did in the mid-2000s), should cause inflation (without helping growth). Instead, we see persistent deflation. So an RBC model of the common type can’t be describing Japan’s world either.

RBC being “real business cycle,” in which slow productivity growth is the driver of a recession. For me personally, this is even less plausible than the Keynesian story. PSST is not RBC.

I think we need to get away from static thinking, including AS-AD and RBC. In static thinking, there is a full-employment equilibrium out there, if everyone would just adjust to it (match the right person with the right job, or cut wages by enough, or whatever). In the dynamic world of PSST, new opportunities to reconfigure production constantly arise. Some of these create ZMP situations, in which (some) workers’ value to the firm drops essentially to zero. These workers are released into the economy as free resources. Entrepreneurs can try to pick up these free resources and do something profitable with them. But it may take some time for entrepreneurs to figure out exactly what this “something profitable” might consist of.

I know nothing about Japan. But if I were looking for the source of its problems, I would examine the cultural, legal, and institutional factors that surround the formation of new businesses. If what you had during Japan’s post-war resurgence was an economy based on top-down industrial policy and cronyism, and what you need to fix the problem today is bottom-up entrepreneurial energy and creativity, then, as Noah suspects, the solution is not going to come from wiggling interest rates and deficits.

Shoot First, Negotiate Later

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No, this is not another post on the Zimmerman case. It is my reaction to an article by Mary C. Dalythese patterns are consistent with the reluctance of employers to adjust wages immediately in reaction to changing economic conditions. In particular, employers hesitate to reduce wages and workers are reluctant to accept wage cuts, even during recessions. This behavior, known as downward nominal wage rigidity, played a role in past recessions, but was especially apparent during the Great Recession. Wage rigidity kept nominal wage growth positive throughout the recession. This led to a significant buildup of pent-up wage cuts, that is, wage cuts that employers wanted, but were unable to make. As the economy recovers, pent-up wage cuts will probably continue to slow wage growth long after the unemployment rate has returned to more normal levels.

Pointer from Mark Thoma.

If no one told you what the data looked like, which would be more plausible?

a) Employers at first are reluctant to let go of employees, and they instead react to a drop in demand by immediately slowing wage growth. If the recession persists, they fire people.

b) Employers at first are reluctant to slow wage growth, so they fire people. If the recession persists, they slow wage growth.

I’m sorry, but (a) seems way more plausible to me than (b). We live in a world where there are a lot of fixed costs of hiring and firing. Yet the authors want to argue that in the short run, the easiest margin of adjustment is to fire people, and then in the long run you hire them back at lower wages.

Now this is a bit better:

As the recovery takes hold, businesses gradually reduce wage growth. At the same time, inflation typically erodes the real wages of workers, relieving some of the pent-up demand of employers for wage cuts. This gradual process can continue long after the unemployment gap begins to narrow. At the same time, slower wage growth also means businesses are able to hire more workers, which stimulates the demand for labor and pushes the unemployment rate down further.

Emphasis added. Still, I hate the phrase “pent-up demand for wage cuts.” It makes it sound as if “gee, if we could just get workers to accept a little lower wage, I could keep all of them.” That is a world in which there are an awful lot of $20 bills lying on the sidewalk.

Instead, I prefer to think of a dynamic economy and ask “what keeps entrepreneurs from finding ways to make use of available resources (unemployed workers)?” To me, that makes a recession more comprehensible, although less treatable.

Nominal GDP and Employment

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The chart comes from Dan Diamond. Pointer from Tyler Cowen.

Let’s pretend that health care is the whole economy. The top line is the growth rate of nominal GDP. The lower line is the growth rate of employment. Growth in nominal GDP is growth in real GDP plus inflation. Growth in real GDP is growth in number of workers plus growth in output per worker. Inflation is growth in compensation per worker plus growth in the price markup over compensation. Putting this all together, we have

growth of nominal GDP = (growth of number of workers + growth of output per worker) + (growth of compensation per worker + growth of the price markup over compensation)

Scott Sumner would say that the two most reliable numbers here are the ones shown in the chart–growth in nominal GDP and growth in the number of workers. The division between nominal GDP and real GDP depends on making the correct quality adjustment for prices, which Sumner would argue is much less reliable than the other two measures. (I think everyone would agree that quality-adjustment is less reliable, but some of us prefer to believe that it is not much less reliable.)

The difference between the two lines on the chart consists of productivity growth, wage growth, and growth in the price markup. Diamond says that wage growth does not account for the slowdown in nominal GDP (although wage growth did decline–I think by about a percentage point, based on the data in Diamond’s link). He alludes to a mix shift. If people shift away from prescription drugs and toward other services, those other services could have lower productivity and/or a lower price markup.

In any case, it looks as if either productivity growth has declined or the growth in the price markup has declined. This should show up as a decline in corporate profits in the health care industry. Can anyone find data? I have trouble navigating the Commerce Department’s web site.

I did stumble across this paper, which tries to decompose the rise in health care spending from 2003 to 2007.

Our decomposition also sheds light on productivity in the treatment of cancer. Over the four-year sample period, expenditure per capita rose twice as fast for malignant neoplasms (48 percent growth in expenditure per capita) than non-malignant neoplasms (24 percent growth in expenditure per capita). A large reason for the discrepancy is the difference between growth in the cost of treatment (that is, expenditure per episode of care). Service prices for malignant neoplasms grew over twice as fast as service prices for non-malignant neoplasms. This may indicate that more expensive and innovative services are playing a role in cancer spending growth.

This is interesting, but for present purposes it is of little use. The chart above shows a slowdown in the rate of growth in overall health spending between 2003 and 2007.

But my main point is that we expect nominal GDP growth and employment growth to line up. If they do not, something must be going on with either productivity, compensation, or price markups. This is a matter of accounting.

ZMP and Gender

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Nicholas Eberstadt writes,

In the early 1950s, practically all men in this age group [25 to 54] were either working or looking for work-fewer than 3 men out of every 100 were out of the labor force. By contrast, over 11 out of every 100 men of prime working age are completely out of the labor force today-one in nine, fully four times the fraction back in the early postwar era. This flight from work at prime working ages accounts for the vast majority of the 13 percentage point drop in employment ratios reported for this key demographic group over the past sixty years (i.e., 1953-2013)

Some comments

1. If you look closely at Eberstadt’s charts, you can see that the decline in adult male employment was at least as large between 1999 and the present as it was from 1950 to 1999. In terms of the rate of change, the decline was gradual until recently, and then it accelerated. In addition, I believe it is the case that the growth in female employment slowed just as the decline in male employment accelerated.

2. If you want to tell a conventional macro story, you could attribute most of what has happened since 1999 to aggregate demand. On the other hand, I think pretty much everyone would agree that the from 1950-1999 we were seeing secular, structural changes that raise female employment and reduced male employment. It would be absurd to tell an aggregate demand story for this. Still, it is interesting that the drop in male employment is not steady, but instead consists of downward ratchets that occur during recessions, while during recoveries male employment levels off and even rises.

3. Continuing with the theme of conventional macro, you might say that what we have seen recently is another downward ratchet in male employment due to severe drops in aggregate demand. This is overlaid on a continuation of the secular decline.

4. The secular explanation would be that low-skilled men have faced increasing competition from capital and from foreign labor.

5. It is not clear what the possibilities are for raising the skills of males displaced by these phenomena.

6. Going forward, one plausible scenario is continued divergence between Vickies and thetes. We should perhaps be thinking more in terms of how to adapt to such an outcome, as opposed to making futile attempts to ward it off.

Quackroeconomics New Title, New Outline

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The title might be:

Macroeconomics Ain’t So

It isn’t what we don’t know that gives us trouble, it’s what we know that ain’t so.

–Will Rogers (?)

The outline might be:

1. Introduction

2. Macroeconomics as I experienced it (how macroeconomic thinking evolved in the 1970s and 1980s, with an autobiographical perspective)

3. Why classical macroeconomics ain’t so

4. Why folk Keynesian macroeconomics ain’t so

5. Why the liquidity trap ain’t so

6. Why the Hicksian IS-LM model ain’t so

7. Why the textbook AS-AD model ain’t so

8. Why Dark Age Macroeconomics ain’t so

9. Why PSST ain’t so, but still might be about the best we can do

Quackroeconomics

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I’m back to that title. Comments welcome on this idea for how it might open:

In discussions of macroeconomic policy in Washington and in the press, these four propositions are taken as given:

(S) Spending is what drives the economy. Spending creates jobs, and jobs create spending. When unemployment is high, the problem is too little spending.

(M) Monetary policy must steer the economy carefully between overheating and slumping. Doing so requires high levels of skill and intellectual resources.

(F) Fiscal policy is just as important. When there is unemployment, monetary policy cannot do the job alone, because the Federal Reserve also has to keep an eye on inflation. So the Federal government must engage in deficit spending to stimulate the economy.

(C) Computer models are essential tools that enable economists to forecast the economy and assess the impact of alternative economic policies. Using computer models, the Congressional Budget Office is able to score the number of jobs a particular policy will add to or subtract from the economy.

These four propositions are what I term quack macroeconomics, or quackroeconomics for short. Like quack medicine, quackroeconomics is unproven, unreliable, inconsistent with the views of leading researchers in the field, and possibly dangerous.

Until now, however, there has not been a book that confronted quackroeconomics head on. Other economists seem reluctant to do so. Instead, they prefer to accommodate it.

Academic economists who would never teach it to students nonetheless write op-eds that employ quackroeconomics. When they come to Washington as economic advisers, they adopt quackroeconomics with alacrity.

The authors of undergraduate textbooks provide theoretical analysis that, if properly understood, discredits quackroeconomics, but such conclusions are never spelled out. As a result, students come away from class with quackroeconomic intuition rather than an understanding of the analytical models.

In graduate school, professors discard what students learn as undergraduates and teach something else entirely. The advanced material is even further removed from quackroeconomics, but by this point it does not matter. Most of these students will never again think seriously about macroeconomics as a whole. Those who are troubled by the discrepancies between quackroeconomic intuition and what is taught in graduate courses are those who are least likely to stick with macroeconomics. Instead, they will go into another economic sub-field, such as environmental economics, economic development, or industrial organization. Those who pursue macro will do so because they enjoy the sort of mathematical puzzle-solving that nowadays leads to a tenured professorship in macroeconomics.

I worded M, F, and C carefully so that just about every economist would disagree with them. In fact, my guess is that many would object that I am attacking a straw man. I believe, however, that this is not a straw man when it comes to economic journalism. If readers spot articles in the press that pertain to this issue, please leave a comment (you do not have to go back and find this post–any post on the blog will do)

Quackonomics Wins

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Shortened from Quackroeconomics, although I still could revert back.

It didn’t necessarily get the most votes in the comments, but it’s the one I can put the most personal oomph into. In fact, I conceive of one of the early chapters as quasi-autobiographical. I will attempt to bring the reader along as my own views on macroeconomics evolve. That might be a risky approach, but we’ll see…

AD-AS, Debunked in One Chart

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In the WSJ blog. It shows the behavior of the Fed’s preferred inflation measure, the year-over-year percent change in core consumer prices in the GDP deflator, over the past several years. Early in 2007, it was 2.6 percent. It is now at its low point, of 1.1 percent. In between, there was a local trough of 1.2 percent late in 2009 and a local peak of 2.0 percent, about a year and a half ago.

If in 2006 you had given this data to practicing macroeconomic forecasters and asked for a prediction about the behavior of unemployment, what would have been the response? My guess is that the majority would have predicted no rise in unemployment at all. The remaining forecasters would have predicted (or inferred, based on an estimated Phillips Curve) a small increase in unemployment in 2009, followed by another small increase in 2012 and 2013. No one would have predicted or inferred an enormous increase in unemployment late 2008 and early 2009, followed by a gradual decrease and then a more pronounced decrease this year.

Let me re-state my concern with measuring aggregate demand as nominal GDP. If inflation remains absolutely constant, then any fluctuation in nominal GDP is arithmetically a fluctuation in real GDP. At that point, “explaining” changes in real GDP by changes in nominal GDP becomes completely circular.

Fiscal Policy and Employment

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So, we had this big fiscal stimulus in 2009, with lousy employment performance. Now, we have so-called austerity, and in addition to the 195,000 jobs added last month, the BLS reports,

The change in total nonfarm payroll employment for April was revised from +149,000 to +199,000, and the change for May was revised from +175,000 to +195,000. With these revisions, employment gains in April and May combined were 70,000 higher than previously reported.

Do Keynesians belong in the always-wrong club?