whenever somebody claims to have a deeper understanding of economics (or actually anything) that transcends the insights of simple models, my reaction is that this is self-delusion. Any time you make any kind of causal statement about economics, you are at least implicitly using a model of how the economy works. And when you refuse to be explicit about that model, you almost always end up – whether you know it or not – de facto using models that are much more simplistic than the crossing curves or whatever your intellectual opponents are using.
Pointer from Mark Thoma.
Shorter version: it takes a model to beat a model
I find that persuasive, although I wish we had a less pretentious term than “model,” which makes us sound more scientific than I believe we are. What I would like to do is compare the state of the IS-LM-Phillips Curve model with that of the PSST model. PSST, or patterns of sustainable specialization and trade, says that a sharp rise of unemployment is the result of patterns of trade made unsustainable by changes in technology and/or asset prices, and that only a gradual process of entrepreneurial trial and error can discover new patterns of sustainable specialization and trade. More about this model can be found here (see items 2,3, and 4).
Some comments:
1. I think that both PSST and IS-LM-Phillips are difficult to falsify. In some sense, the macroeconomic data are over-fit, so that the dataset cannot be used to decisively reject one model in favor of another.
2. I would counter one of Krugman’s narrow points, where he says that the liquidity trap explains why the huge reserves in the banking system have not had major effects. If this is true, then why did the Fed need to pay interest on reserves? I assume that the Fed thinks that if they had not paid interest on reserves, then its huge injection of reserves would have caused rapid money growth and high inflation. It would be interesting to poll economists on whether they would agree–my guess is that most would. It seems to me that Krugman would have to say “no” to the poll, but perhaps I am misunderstanding him. I am not sure how I would answer such a poll myself.
3. I do not align myself with those who see the Fed as the prime mover of inflation. My “model” of inflation is a pretty weak one. Basically, I just think that businesses get into habits about how much to raise workers’ wages each year. Maybe those habits are affected by the aggregate unemployment rate, as in the Phillips Curve, but I would caution that we do not have homogeneous “labor.” Some folks can be getting regular raises that are large, while others may fail to get raises at all. Each business looks at its own labor market, not at the economy-wide unemployment rate.
What about the 1970s? I would say that the 1970s were a period of “inflation consciousness.” Everyone became aware of it, and “cost-of-living” raises got built into the system, because so many employers incorporated recent inflation into current wage increases. I am tempted to suggest that the advent of wage-price controls starting in 1971 had the adverse consequence of raising inflation consciousness.
What about hyperinflation? I believe that really, big, long-term inflation is a fiscal phenomenon. That is, the government runs huge deficits, people stop lending to government, and then it meets its deficits with paper claims. We are not at that point in the U.S., but if we ever do reach the point where bond investors lose confidence–watch out.
4. So I have a PSST model for unemployment, and my “weak” model[s] for inflation. I think it is fair to criticize them as “just-so stories.” But I would say the same thing about the sorts of models preferred by Blanchard or Krugman. Just-so stories, dressed up in pretty math.
5. Elsewhere, Krugman writes,
Basically, the new IO [industrial organization, the field of recent Nobel Laureate Jean Tirole] made it OK to tell stories rather than proving theorems, and thereby made it possible to talk about and model issues that had been ruled out by the limits of perfect competition. It was, I can tell you from experience, profoundly liberating.
Your model of inflation seems to be at odds with the weak form of the quantity theory of money, that on average and in the long run the price level is correlated to the size of the monetary base (or expectations of the future path thereof); an idea going back all the way to Hume at least.
Is there a way to reconcile these two perspectives, or are they genuinely opposed to one another?
I see them as opposed. The problem is that the period of time it takes for the quantity theory to hold is longer than the period of time over which financial markets, and the definition of money, remain stable.
Thank you for your quick response.
It seems that you are saying that, in the short run, the Fed is pushing on a rope that is really being tugged by market forces, but the central bank’s reactions tend to correlate, in a sporadic way, with the movement of the rope, and so mainstream Macroeconomics reverses the direction of causality.
If that were true, however, wouldn’t we see some strong signal, in response to the Fed’s quantitative easing, of a gap between short and long term inflationary expectations? So, the Fed would ease, and it would appear to be impotent for short-term TIPS-spreads, but increasingly inflationary for respectively longer-term rates.
It seems to me that standard macro *has* been falsified. To put it in less pretentious terms, standard macro has a long history of making predictions that fail terribly. Worse, as shown in your macro memoir, it has now been repeatedly stitched up, only to have the stitched-up version also fail.
You may well be right, that some questions just don’t have a robust scientific theory that we will ever find. A field’s insiders will rarely conclude this about themselves, but it is surely often true. Sometimes our best is not good enough.
To the extent that is true, I don’t think it’s healthy to go on developing ever more theories that are not particularly intended to reflect reality. It’s better to modify the questions into something that can actually be answered.
Arnold,
Your concession as to the role of just-so-theories in economics strikes me as significant, and even surprising. As I regard you as a serious thinker, I must rule out the conclusion that economics is idle prattle to you. But what is it?
To the extent that economics is based on story telling, what is it in the nature of that narrative habit that sustains economics as a worthwhile form of thinking about human interaction?
I hope, in writing this, I don’t sound cynical or facetious. Increasingly, I get interested in the role of (rational) ignorance, which all conceivable societies are inevitably affected by in very considerable measure; and I wonder, how do we manage the vastness of our (rational) ignorance so well – in countries such as the US or Germany, where life is quite bearable?
The consideration that (rational) ignorance is a virtually invariant phenomenon in all modern societies including all conceivable improved versions (such as, say, a significantly more libertarian society), has led me to become a lot more respectful of politics and the state (as a functional necessity that, of course, may fail) than I used to be, their tremendous dangers and deficiencies notwithstanding. Politics and the state seem to be (a) the result and (b) the instrumental basis of more or less successful story telling.
For politics seems to be involved in seeking out procedures indispensable in dealing with large amounts of irreducible (rational) ignorance.
We need to tell us reassuring stories to sustain sufficient levels of trust while living in a largely anonymous society.
Politics is a spontaneous order – a hugely important aspect of spontaneous order totally disregarded by Hayek – that serves as a discovery procedure whose (functionally desirable) end product is an at least minimal level of trust etc. needed to support social order. A highly narrative enterprise, full of just-so-stories.
If there is something to this view, what role does economics play in it with its just-so-stories?
I limit the scope of “just-so stories” to macroeconomics. Microeconomics often generates predictions that are falsifiable.
Politics is what happens when we have to tell people:
“Sorry, serious economics cannot handle conclusively issues like unemployment or the nature of an advisable monetary regime.”
And macroeconomics is what happens when economists participate in politics.
Seriously, if there are vital topics of an economic nature that cannot be covered in a scientifically sound way, then there must inevitably develop a part of economics that deals in and is based on rhetoric and techniques of persuasion – not necessarily as something to be maligned, but possibly as a cultural pattern of mutual reassurance, just like free speech may work very well in maintaining peace (social order) even though what is being exchanged is partly of an acrimonious and a generally nonsensical nature, as the case may be.
“I assume that the Fed thinks that if they had not paid interest on reserves, then its huge injection of reserves would have caused rapid money growth and high inflation.”
Hardly. Their reasons were to recapitalize the banks while accessing the bank reserves for their own lending and to exert positive control over the overnight rate rather than have it bounce around erratically. If they had any fear of inflation they would have ended their creation much sooner (though there have been the inflationistas that have been predicting it for years now).
I do see the Fed as only one component of inflation and not necessarily the the principal one which also includes demographics, real growth, deficits, and exchange rates, along with considerable inertia, not powerless but wanting to appear powerful while exerting as little as they can, to under dampen rather than over dampen and risk exacerbating, and ratifying or vetoing inflation rather than creating or destroying it and more in the rate of change than inflation itself.
It
Interest on excess reserves were a way to recapitalize the banks and calm things down during the panic. Now they are another tool to use during the next panic/recession seeing as we are at the zero lower bound. A credit crunch will be less severe if people know the Fed is bailing out the banks via IOER.
It can also use the IOER to manage the normalization of monetary policy and bank lending as the economy recovers.
Most money is created by banks through the process of lending, creating loans and deposits simulatenously. The banking system as a whole cannot lend reserves as new lending creates both a new loan and a new deposit, leaving total reserves across the banking system unchanged.
Excess reserves can be drained by bank deposits converting into paper currency or by Fed balance sheet activity (selling securities, reverse repo).
There was never any danger of significant excess reserves causing rapid inflation and money growth directly: it only becomes an issue when the Fed seeks to hike interest rates, as no one will bid up the price of reserves when everyone has significant excess balances.