Category Archives: PSST and Macro

DSGE Models–Blogs vs. Academics

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Tyler Cowen writes,

The blogosphere is more likely to criticize DSGE models, whereas the profession is more likely to see such models of as providing discipline for any business cycle explanation, Keynesian included.

…On all of these questions my views are closer to those of the specialists in the economics profession.

I count myself as strongly opposed to DSGE models. In my view, macroeconomic models are much more speculative and metaphorical than microeconomic models. Take supply and demand. In microeconomics, I believe that when you draw a supply and demand diagram, you are providing an interesting theoretical description that has empirical use. But “aggregate supply and demand” does neither.

DSGE constrains macroeconomic models to describe a “representative agent” undertaking “dynamic optimization.” This constraint does not make macro models any less speculative or metaphorical. The advocates of DSGE implicitly claim that a certain mathematical approach is both necessary and sufficient to make macro models rigorous. I view that claim as a baloney sandwich.

Adding Knut Wicksell to the List of the Wrong

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Tyler Cowen writes,

I don’t think I ever wrote this view up, but I was of the same opinion nonetheless.

He refers to a post by Paul Krugman arguing that the Fed’s purchases were not what was holding bond rates down. Cowen notes that this week’s rise in interest rates increases the probability that they were wrong.

I would add myself to the list of economists who have some ‘splainin’ to do. I am always willing to be counted among those who doubt the Fed’s power over interest rates, especially long-term real rates. By the way, Scott Sumner used to say that a rise in long-term interest rates could be a bullish indicator. Would he say that now? UPDATE: No.

Or, take Knut Wicksell. He’s not around to defend himself, but I interpret him as saying that the real interest rate will tend to move in the direction needed to reach the natural rate of unemployment. The real interest rate only rises if we are in danger of going below the natural rate of unemployment. In what way has that danger increased this week?

I suppose one could tell a story that says that the market respects the Fed’s forecasting ability. Further, suppose that the market’s view of the latest Fed moves is that the Fed has a surprisingly upbeat forecast for the economy, or else a surprisingly downbeat view of the natural rate (meaning that the natural rate is perhaps close to 7.0 percent). That in turn would mean that the market should revise upward the mean of its distribution for interest rates. Note that the drop in the stock market is more consistent with a newly-bearish view of the natural rate than with a newly-bullish view of the economy.

I am not sure that Knut would want to go to the mat to defend that story, but what else has he got? I fall back to the view that financial markets moves are not really subject to interpretation in terms of macroeconomic models.

Investment and Employment

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Reacting to my post on capital-labor substitution, reader points me to this analysis.

This excess rise in the capital-labor ratio highlights the negative effect of Federal Reserve
policy on wages and unemployment. The persistent, extremely low interest rates are
keeping real wages from climbing and retarding the rate of hiring. The Federal Reserve is
making unemployment worse than it has to be.

Putting on my macro hat, I would say that we are talking about too many endogenous variables here, meaning variables that depend on what is happening to other variables. The capital-labor ratio depends on investment and on hiring decisions. The real interest rate depends on supply and demand factors in the capital market. And so on.

In general, when investment is high, you might expect the demand for labor to be high. This could be because capital and labor are complementary. Even more, from a textbook Keynesian perspective, investment is spending, spending is economic activity, and more economic activity means more employment. The late 1990s exemplify this, with strong investment and a high ratio of employment to population.

Again, from a Keynesian perspective, one expects in a slump that hiring will be low, investment will be low, and real interest rates will be low. All of these are endogenous to whatever caused the slump.

Now, let me put on a PSST hat, meaning that I look at the economy entirely from a structural perspective, not from a Keynesian perspective. I would say that for the past fifteen years, we have seen both capital-labor substitution and factor-price equalization. Both of these require a reallocation of labor. This is not taking place very quickly. What are the reasons? Some possibilities:

1. Weak incentives for the unemployed to take jobs that require a loss of status or an adverse relocation. Older unemployed people can collect disability. Younger unemployed people can live with their parents.

2. Unusually few fast-growing firms. Perhaps entrepreneurs are not finding ideas that pan out. Perhaps when things pan out they are finding ways to grow quickly without adding thousands of workers (think of Internet businesses).

3. Perhaps the labor-leisure choice is being driven by attitudes about health insurance. If you really care a lot about health insurance, you take a job, even if you think that the take-home pay is barely worth it. The same deal gets turned down by someone who does not value health insurance. With the health insurance component of compensation so high these days, this can be important.

The Stock Market

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Even after yesterday’s 2-1/2 percent drop, the S&P 500 is still higher than when I wrote

if the stock market is up on the basis of little or no positive economic news otherwise, then that sort of says that the reason people are buying stocks is because the market has been going up. That’s not what one would call a sustainable model.

The financial pages say that markets have realized that the Fed cannot keep monetizing large deficits forever. And this is news because…..?

I am one economist who makes a point of not giving an economic interpretation to stock market moves.

Aggregate Supply and Demand

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A lot of economics bloggers have been discussing the merits and flaws of the paradigm of aggregate supply and demand. Mark Thoma linked to a couple of the more recent examples.

I think that, viewed on its own terms, AS-AD is confusing (or confused). That is, mainstream economists do not know what to put on the vertical axis. If you put the price level on the vertical axis, you get a nice textbook model, but no connection to the real world, where economists talk in terms of inflation rather than the price level. On the other hand, if you put inflation on the vertical axis, that does not work very well, either, as I explain in this 8-minute video. (Comments, other than about my handwriting, are welcome.)

I developed PSST as an alternative to AS-AD. PSST does not appear to explain nearly as much as AS-AD. That may look like a feature in AS-AD, but on closer inspection it is a bug. The explanatory “power” of AS-AD is a delusion.

1. The AS-AD paradigm is invoked to explain changes in the combination of inflation and unemployment. If one goes up while the other goes down, we call this an aggregate demand shift. If both move in the same direction, we call this an aggregate supply shift. Thus, we can explain anything. But there is a lot of hand-waving involved. The stories we tell about AD and AS are always post hoc, just-so stories.

2. In the 1970s, we had a huge rise in the combination of inflation and unemployment. What caused this? The rise in the price of imported oil is often cited, but it cannot possibly account for the large acceleration in inflation. At most, it would cause a temporary increase in inflation, followed by a decrease. Many (most?) macroeconomists attribute the 1970s disaster to a “rise in inflation expectations.” Prices rose because they were expected to rise. Through habit and repetition, we have come to accept this story. But how intellectually satisfying is that?

3. Turning to events since 2008, the typical macroeconomist describes the rise in unemployment as the result of a “demand shock.” However, they do not all agree on what the shock was. Scott Sumner says that it was a contraction by the Fed. Others say that it was the wealth effect of a decline in house prices. Others say that it was a credit crunch. Others say that it was the effect of inflation dropping too close to zero. All of these are just-so stories.

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. (Note to Scott Sumner: yes, the decline in nominal GDP growth was much bigger than the decline in inflation. But that only restates the mystery–it doesn’t solve it.)

The terms “aggregate demand” and “aggregate supply” are highly loaded. That is, they lead economists to imagine something analogous to supply and demand in microeconomics. But the analogy is mostly misleading, and economists who invoke AS and AD are the ones who are most misled.

Connecting Household Balance Sheets to PSST

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Interesting comment found by Glenn Reynolds. From Jeffrey Levin:

If you dig around and research start-ups you will find that the majority of start-ups are funded by second mortgages or HELOC draws. Due to the housing crash, that equity is just not there for the vast majority of people looking to start up a new business. Its one of the large reasons why commercial credit expansion has been so moribund. Without getting off the ground from seconds or HELOC’s all those startups that would have made it past year 1 and then been able to obtain standard commercial business loan never got off the ground and thus never graduated to commercial loan financing. You have to walk first before you can run. Startups don’t start in the commercial loan department (at least most of them don’t).

Recalculation means discovering new patterns of sustainable specialization and trade. Doing so requires entrepreneurial trial and error. As Levin points out, the stereotypical 20-year-old in a garage is actually atypical. Most entrepreneurs are like I was, forty years old and risking accumulated wealth. If my wealth had suddenly been halved in 1993, I doubt that I would have started a business in 1994.

And whose wealth got crushed by the housing crash? According to a paper by Edward Wolff, as cited in the WSJ blog:

The big drop in home prices between 2007 and 2010 meant a 59% loss in home equity for people under 35, compared with just 26% for people generally. That meant a massive loss of wealth, or “net worth” — what people own minus what they owe. People ages 35-44 saw a 49% fall in home equity.

Thanks to Mark Thoma for the pointer.

Home Ownership’s Negative Employment Externalities

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David G. Blanchflower and Andrew J. Oswald write,

We explore the hypothesis that high home-ownership damages the labor market. Our results are relevant to, and may be worrying for, a range of policymakers and researchers. We fi nd that rises in the home-ownership rate in a US state are a precursor to eventual sharp rises in unemployment in that state. Th e elasticity exceeds unity: A doubling of the rate of home-ownership in a US state is followed in the long-run by more than a doubling of the later unemployment rate. What mechanism might explain this? We show that rises in home-ownership lead to three problems: (i) lower levels of labor mobility, (ii) greater commuting times, and (iii) fewer new businesses. Our argument is not that owners themselves are disproportionately unemployed. Th e evidence suggests, instead, that the housing market can produce negative externalities’ upon the labor market. Th e time lags are long. Th at gradualness may explain why these important patterns are so little-known.

Pointer from Steve Goldstein of the WSJ.

I would suggest viewing these findings as tentative at best. As the authors write,

We are unable, in this paper, to say exactly why, or to give a complete explanation for the patterns
that are found

There are many conceivable explanations for the findings. Bear in mind that conventional macro distinguishes between cyclical and structural unemployment. To aggravate structural unemployment, home ownership would have to result in permanent mis-matches between skills and labor demand. To aggravate cyclical unemployment, home ownership would have to make wages stickier, or somesuch. In a PSST framework, home ownership would have to make it more difficult for entrepreneurs to discover new forms of comparative advantage.

I personally would rate as low the probability that there is truly a causal relationship between home ownership rates and subsequent unemployment rates. Still, it is refreshing to see a paper that runs counter to the “home ownership is great” mantra.

Creating Unsustainable Jobs

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Anthony Randazzo writes,

Only 23 percent of the 8,381 companies we were able to contact in our sample hired new workers to complete their stimulus project and kept all of them once the project was done. In other words, more than seven out of 10 companies did not hire workers at all or had to lay off the workers they did hire.

Of course, this is only microeconomics. Macroeconomics tells you that the stimulus injected money into the economy, and therefore it increased employment. The employment increase would not necessarily show up at companies that were the initial recipients of the money.

I’m not being entirely sarcastic. There simply is no reliable way to demonstrate how well the stimulus worked. I do not think that this study refudiates the stimulus.

For those of you new to this blog, I do not subscribe to the Keynesian story, in which spending creates jobs and jobs create spending. I think that comparative advantage is what creates jobs. To put it more carefully, comparative advantage creates the opportunity for people to sell labor and buy goods and services in the market. Entrepreneurs who identify these opportunities create jobs.

In today’s economy, I believe that the link between spending and jobs is weak. That is because, as Garett Jones put it, today’s workers do not build widgets. They do something fuzzier, which Jones terms creating organizational capital. Whether you like that term or not, I think it is fair to say that there is a large element of investment in a hiring decision these days. You do not want to hire a worker unless you are confident that the time you spend training and acclimating the worker to your company will be repaid in the form of a more effective enterprise. You do not want to let a worker go unless you are confident that the worker adds so little to the effectiveness of the enterprise that you would be better off not having to compensate that worker.

In 2008, the reluctance to fire surplus workers went away, and the reluctance to hire possibly-useful workers increased a bit. So a lot of the decade’s job destruction got telescoped into a short period of time. Why have new jobs not been created? Some possibilities:

1. Firms in 2008-2009 did a very good job of discriminating between useful and less-useful workers. The ones they let go were less useful. There has been some back-and-forth between Bryan Caplan and Tyler Cowen suggesting that this has turned the long-term unemployed into a “lemons” market.

2. The choice of “going on disability” has become attractive.

3. The “wedge” between wages and compensation has gone up (think of employer-provided health insurance).

4. Firms that have developed popular goods and services no longer expand by rapidly ramping up employment. They can increase production by using overseas suppliers and automated manufacturing. They can increase sales by using online channels rather than hiring sales clerks.

S – I = G – T

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Recently, I have seen two pieces that brought up the issue of corporate saving. Tyler Cowen cited Martin Wolf on the high corporate saving rate in Japan. John Mauldin reproduced an essay arguing that the ratio of corporate profits to GDP is currently above normal.

Consider some basic national income accounting, and simplify by ignoring international capital flows. We have

S + T = I + G

which means that

S – I = G – T

On the left, we have net private saving, which is private saving minus investment. On the right we have the government deficit.

We can separate private saving into saving by corporations and saving by individuals. Corporate saving consists of profits that are not invested (call this E). Call saving by individuals P. Then we have

S – I = E + P = G – T

So why is E so high? From a pure accounting standpoint, when the government runs a big deficit saving has to be high elsewhere. If individual savings flows do not rise, then the savings must flow to corporations.

Hyman Minsky viewed this as a causal model. Government dis-saving turns into corporate profits. He thought that this was how Keynesian deficit spending worked–it siphons profits into corporations. When they are in their conservative mode (“hedge finance”) they will only invest if their balance sheets are strong, so that is why you need deficits to recover from a financial crisis.

I think it is often misleading to treat accounting identities as causal models. But by the same token, when you propose a causal model you should work it through in terms of the identities. And I do not think that one should treat corporate profits as some sui generis phenomenon.

Both Japan and the U.S. have run soaring deficits. From an accounting perspective, there has to be an offsetting increase in saving somewhere in the private sector. Note that corporations are owned by people. So there is a sense in which the question you should be asking is, “Why are people choosing to do so much saving indirectly, via corporations, rather than in personal accounts?” Rather than attach great economic significance to this, as Cowen and Mauldin are inclined to do, I would guess that institutional habits and/or tax incentives are the story.

Scott Sumner Explains the Monetary Approach to Macroeconomics in Nine Lessons

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The index is here. Highly recommended.

For my perspective on this topic (including where I disagree with Sumner), see my “million mutinies” essay series:

part one

part two

part three

In the last essay in my series, I wrote

For mainstream economists, the financial crisis has produced a new intuitive model of the economy which has yet to be articulated in any formal theory.

Scott Sumner, on his blog The Money Illusion, articulates what I believe would have been the consensus five years ago, which is that fiscal and monetary policy (he emphasizes the latter)—as opposed to bank capital management—are the tools of macroeconomic stabilization. Today, his views are classed as “heterodox.”

I write so much that I sometimes forget earlier pieces that meant a lot to me, such as this one. I was looking for some more “color” to add to this post, and I stumbled on the series.