Category Archives: PSST and Macro

PSST–It’s Raghuram Rajan

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He writes,

It is easy to see why a general stimulus to demand, such as a cut in payroll taxes, may be ineffective in restoring the economy to full employment. The general stimulus goes to everyone, not just the former borrowers. And everyone’s spending patterns differ – the older, wealthier household buys jewelry from Tiffany, rather than a car from General Motors. And even the former borrowers are unlikely to use their stimulus money to pay for more housing – they have soured on the dreams that housing held out.

Pointer from Tyler Cowen.

The question I pose is whether workers will return to old jobs or whether new jobs have to emerge. My belief is the latter.

Where are the Macroeconomic Bulls?

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Bill McBride writes,

the 780 thousand housing starts in 2012 were the fourth lowest on an annual basis since the Census Bureau started tracking starts in 1959. Starts averaged 1.5 million per year from 1959 through 2000. Demographics and household formation suggests starts will return to close to that level over the next few years. That means starts will come close to doubling from the 2012 level.

Residential investment and housing starts are usually the best leading indicator for economy, so this suggests the economy will continue to grow over the next couple of years.

Another area of pent-up demand is the auto sector. How many cars would have to be sold over the next two years to reduce the average age of the U.S. auto stock from 11 years to 7 years? Is 7 years even too old?

The “oil tax” is going down. Even if the price of oil does not decline, the U.S. is becoming more of a producer and less of a net consumer.

If you think that the depressed economy was caused by weak private-sector balance sheets and de-leveraging, then, as McBride points out, our troubles are over. Also, the stock market has trended up since 2008.

It seems to me that more macroeconomists should share McBride’s bullishness. If you think that the economic activity consists of spending, then all signs point to a surge in spending over the next two years.

At a place like the Fed or CBO, I can imagine that few people want to forecast an economic surge. Calling a turning point in the economy is hard. It is much safer to project a continuation along recent trends, and then to revise your forecast when it becomes clear that the trend has changed. Also, the bulls of 2009 and 2010 must be feeling sheepish today, leaving the bears with more clout in the room.

I do not believe in the “economic activity = spending” mainstream view. The PSST model does not make me either bullish or bearish at this point. I would forecast something like normal growth in real output, say 3 percent, over the next two years. That should make me a pessimistic outlier, because the mainstream economists should be forecasting at least 5 percent real economic growth over the same period. But apparently not:

In a survey of economists the Federal Reserve Bank of Philadelphia conducted in the fourth quarter, individual forecasts for the change in gross domestic product from the end of 2012 to the end of 2013 were unusually clumped around the average forecast of a 2.3% gain. The forecast at the top of the 25th percentile—that is, a pessimistic outlook in which three-quarters of forecasts were higher—was for a 2.1% increase in GDP. The forecast at the 75th percentile, or the optimistic camp in which just a quarter of forecasts were higher, called for a 2.5% gain.

The Greek Phillips Curve

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Tyler Cowen writes,

Prices are sticky, AD is falling, and almost all of the adjustment is in quantities. Yet this still doesn’t explain why prices are inching up, and furthermore it is grossly at variance with the actual empirical literature on price stickiness (much neglected in the blogosphere I should add), which is not nearly as strong as wage stickiness.

This is one of several explanations Tyler finds unsatisfactory for the fact that unemployment is so high in Greece and yet inflation is still greater than zero there. In a follow-up, he writes,

For a simple point of comparison, the rate of U.S. price deflation in 1932 was greater than ten percent with overall deflation running at about twenty-five percent over a period of a few years. More recently, Japan had nine straight years of core CPI deflation and Greece cannot even manage anything close to that. Just what is the Greek Phillips Curve supposed to look like?

I recommend a recent article by Marga Peeter and Ard den Reijer. I may be confused about what I am reading, but it appears to me that the Phillips Curve in Greece shifted adversely over a period of a decade. To put this another way, the natural rate of unemployment in Greece may be quite high.

If my reading is correct, then aggregate demand policies, including converting to a cheaper currency, would not do much for Greece. If workers’ reservation wages are high relative to productivity, you are going to have a lot of unemployment.

The Recession and World Trade

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From the DHL Global Connectedness Index 2012.

The Netherlands retains the top rank on this year’s DHL Global Connectedness Index, and 9 of the 10 most connected countries are in Europe.

Pointer from Timothy Taylor. (How does he find these things?) Taylor writes,

Globalization is near an all-time high by this measure [world exports of goods and services divided by world GDP], but notice that it after the drop associated with the Great Recession, this measure of globalization is about the same in 2011 as it was in 2007.

It is not clear why a statistic with GDP in the denominator should experience a drop during a recession. However, my guess is that the answer has to do with the location of the recession. If some emerging economies continued growing while Europe slumped, one would observe world GDP holding up better than world trade.

From a PSST perspective, all GDP is trade. Some of it is intra-border and some of it is cross-border. Trade patterns that were based on unsustainable conditions, primarily inefficient firms remaining in business, were broken by the conditions that emerged in 2008. Firms go out of business all the time. All the time, new businesses are starting and some are growing. I take the view that since 2008 an unusually large number of troubled firms failed and unusually small number of high-growth businesses emerged. To me, calling this a decline in aggregate demand is begging the question–it is simply putting another label on the phenomenon, not explaining it. It could be that stress at banks is a cause of it, but I think instead that it is a symptom. But that leaves me struggling to tell a story that accounts for the sudden, sharp drop in GDP that took place in 2008-2009.

Money, Inflation, and Wile E. Coyote

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Before 2008, the bubble that some economists expected to pop was the value of the dollar. Paul Krugman used a colorful metaphor to describe this.

So it seems likely that there will be a Wile E. Coyote moment when investors realize that the dollar’s value doesn’t make sense, and that value plunges.

I found this in an old post from Mark Thoma. Feel free to use Google to find other citations.

Nowadays, when he looks at the prices of U.S. government bonds, Krugman sees rational expectations at work. He looks at the low long-term interest rates as a sign of the market’s wisdom in predicting low inflation for ten years.

But what I see is a market that could have a Wile E. Coyote moment. Once enough investors decide to dump our bonds, interest rates will rise. It will become clear that at those interest rates the government cannot afford to pay off the bonds, so more investors will dump bonds. etc.

Now the Fed can always buy our bonds. It is doing a lot of that, and I can see where an investor with a sufficiently short time horizon who believes that he won’t be the one still holding bonds when they start to lose value might say, “Don’t fight the Fed. Just ride the yield curve for a little while longer.”

But suppose that our Wile E. Coyote moment comes when inflation has been heating up. (Indeed, the Wile E. Coyote moment could come because inflation heats up, and at that point investors decide that the Fed may no longer be their friend.) Under this scenario, the Fed wants to be a bond seller, not a bond buyer, in order to keep inflation in check. If the Fed feels constrained not to sell too many bonds, then inflation could really take off.

How can I justify a fear of inflation, given recent behavior? In recent years, the Fed has created a lot of money, and we have not seen a lot of inflation. What is going on?

1. Perhaps money and inflation have no connection. We should go back to using the Phillips Curve. When unemployment is high, inflation is low, and conversely. After all, wages are 70 percent of costs, and it seems unlikely that wage inflation will get much traction with folks having a hard time finding jobs.

2. Perhaps we are suffering from tight money. This is the Scott Sumner argument. Money and inflation (he would prefer nominal GDP) are related, inflation is low, ergo we must have tight money.

For the short run, I believe something like (1). However, I am old enough to remember the 1970s. Based on that experience, I would say that inflation is subject to regime shifts. There is a regime in which inflation is low and relatively stable. There is another regime in which inflation is high and volatile. Finally, there is a regime of hyperinflation.

I think that with enough persistence, the Fed can move us between the low, stable regime and the high, volatile regime. The Fed spent the 1970’s getting us into the high, volatile regime, and it spent the 1980s getting us out of it.

Hyperinflation is a fiscal phenomenon. A government that can balance its budget is never going to have hyperinflation.

The scenario I have in mind is one in which the economy has begun to shift to the regime of high and volatile inflation. Then the Wile E. Coyote moment arrives, and the Fed feels pressed to keep the U.S. bond market “orderly” by not selling bonds. In fact, interest rates are rising so quickly that the Fed decides that it needs to buy bonds. This sets off a spiral of money-printing and price increases, threatening to bring on hyperinflation. In which case, the bond market will not be orderly. Nor will anything else.

Fake Wealth

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Michael Munger writes,

If you measure from the peak of the bubble, we lost a lot of wealth. But that wealth was entirely fake, created by a revved up demand for houses as assets expected to appreciate rapidly.

Pointer from Mark Thoma. As Tyler Cowen would say, “We’re not as wealthy as we thought we were.”

If you are a Keynesian, fake wealth is a good thing. It is well known that deficit spending is pretty much useless if there is “Ricardian equivalence,” meaning that people realize that in the future their benefits have to go down and/or their taxes have to go up. However, I am a firm non-believer in Ricardian equivalence, as you might have noticed when you read Lenders and Spenders.

So if I thought that economic activity consisted of spending, then I would expect deficits to increase spending and economic activity. Instead, I think of economic activity as patterns of sustainable specialization and trade, and I do not think that deficit spending is helping, because it is so unsustainable.

To put this another way, I think that long-term government bonds are fake wealth these days. There has to be some kind of default on future government commitments. There is an off chance that the future commitments that get cut will be entitlements. There is an even more remote chance that the government will find tax revenue to cover all of its commitments. We can inflate away some of our past debt, but since our projected future deficits are even higher, inflation does not make the problem go away. So I think that it is likely that we will get some sort of default. The fake wealth will be marked down at some point in the future, either through inflation or default.

Once upon a time, we had an Internet bubble that gave us dishonest stock prices. Let us stipulate that it was caused by private sector shenanigans. When that collapsed, it was followed by a housing bubble. There were private sector shenanigans involved in that one, too, but I think that some of the fingerprints on the housing bubble belong to government officials. The fake wealth that is being created now? Pretty much entirely government-generated.

Happy New Year.

EMH and Macroeconomics

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A reader asks,

if an economist comes up with a novel and correct theory that makes predictions about macroeconomic variables, shouldn’t this theory enable him to beat the markets using these predictions?…

Therefore, it seems that if we accept both the EMH and the basic validity of macroeconomics, the latter must be about predictions that are somehow novel, correct, and non-trivial, but at the same time provide no new information about future market prices, even in terms of crude probabilities. But what would be some examples of these predictions, and what principle ensures their separation from market-relevant information?

Consider financial variables, such as the long-term interest rate or the price-earnings ratio of the overall stock market. According to the efficient markets hypothesis, these are not predictable on the basis of known information. To put this another way, you cannot beat the market forecast for these variables.

On the other hand, in conventional macroeconomics these variables can be predicted using models and controlled using policy levers. Reconciling this with the EMH has challenged economists for decades. Here are various alternative ways of doing so:

1. Policy has no effect. Markets do what they will do, regardless. The market uses the best prediction model, so economists’ macro models can, at best, replicate the market’s implicit model.

2. Policy has an effect, but markets try to anticipate policy. The expected component of policy has no effect. Only policy surprises have an effect.

It seems to me that the market monetarists (e.g., Scott Sumner) believe something closer to (2) than to (1). But (2) can get you into some strange conundrums. Does the Fed have free will? That is, does it have the ability to surprise markets, other than by acting randomly? If its actions are not random, they should be anticipated by markets. If they are anticipated by markets, then they should have no effect. etc.

I prefer a third way of looking at things, which might be expressed in the work by Frydman and Goldberg. That is, there is no reason for all participants in markets to be using the same model. They have different information sets. The EMH is a useful guide to everyone, because it serves as a reminder that it is unwise to assume that your information set is somehow superior. However, it is not correct to impose “rational expectations,” in which everyone uses the same model.

A challenge with this “multiple information sets” view of the world is that we all trade in the same market. I think that people who own long-term Treasuries and people who own gold have different expectations for inflation. Why does someone not combine short positions in bonds and gold in order to arbitrage against these different expectations? I am afraid that one has to make risk aversion and leverage constraints do a lot of work.

From this perspective, the response to policy changes is hard to predict. For both economic modelers and policy makers, a difficulty is that you do not know which models the market participants are using. Thus, you cannot know how markets will react to policy moves.

I think that such humility is appropriate. Arguments of the form “on x date the Fed did y and subsequently z happened, just as my theory would have predicted” are not persuasive to me. One can usually find other instances of the Fed doing something like y with different results.

Incidentally, I recently re-read Perry Mehrling’s biography of Fischer Black. Black was perhaps the first economist to think about the contrast between modern finance theory and conventional macro, and Black was the first and perhaps the only one to attempt to recast macro entirely in terms of modern finance. Continue reading →

The 1920s as a Housing Bubble?

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Stephen Gjerstad and Vernon L. Smith (GS) take that view.

Most notably, housing expanded rapidly by nearly 60% from 1922 to 1925, leveling out in 1926 and then began its long descent, not bottoming out until 1933. In 1929 new housing expenditure had returned to its 1922 level before any of the remaining expenditure categories had declined more than small temporary amounts…the 60% increase in the rate of new home construction expenditures from 1922-1925 was matched by a 200% increase (from $1B to $3B) in the net flow rate of mortgage credit.

This sound similar to the more recent episode. That is, much of the decline in housing construction was already behind us when the bottom dropped out of the rest of the economy. GS point out that the credit boom in the late 1920s did not raise house prices as it did more recently, because (they argue) in the 1920s the housing supply was more elastic.

Edward Leamer, in Macroeconomic Patterns and Stories, shows that spending on housing and consumer durables generates much of the variation in GDP growth relative to trend. However, in the typical recession, as GS also note, the decline in housing construction coincides more closely with and accounts for a larger share of the decline in GDP. Continue reading →