The Ambrosini Critique

Flipping through this paper on expectational shocks, I was at first surprised at the behavior of consumption to irrational exuberance. Consumption goes down at first but as the as exuberance wears off consumption goes back to normal. This makes sense, on reflection, because if you irrationally think your investments will have high returns in the future, you’ll consume less now and invest more. When you realize that you’ve been all a fool, you reduce your investments and start consuming again.

This got me to thinking about what people are pessimistic about these days. If this fear is the opposite of irrational exuberance (i.e. we believe investments in the future aren’t going to pay off as much as they will) then we’d actually see an increase in consumption per the logic of the paper above. So it can’t be that.

But then what is driving precautionary savings? What are people afraid of? What do people mean when they say we need to bolster confidence?

Even if interest rates are zero and there’s a flight to risk (rationally or not), if people believe credit will be available tomorrow, there’s no reason for precautionary savings. Are people afraid credit won’t be available in the future? is credit unavailable to the unemployed? do people think its not?

New GDP stats here. That’s “moderate evidence that psychology matters“.

That’s New Economic Papers – Macroeconomics:

• “We provide empirical support for a DSGE model with nominal wage stickiness where growth is driven by learning-by-doing and money shocks and their variance are allowed to impact on long-run output growth.”
• “We extend and estimate the initial model on US data to account for specific shocks that destroy the stock of capital and…”
• “Our model is calibrated to match the steady-state distribution of price adjustments in microdata; realism calls for firm-specific shocks.”
• “…we address the causes of the Roaring Twenties in the United States. In particular, we use a version of the real business cycle model to test the hypothesis…”
• “Household Labor Supply and Home Services in a General-Equilibrium Model with Heterogeneous Agents”

Out of about 30 papers, there was one pure theory paper and the rest were testing models with real live data. Its uncertain if these authors were of the fresh- or salt- water variety.

It is models of the economy using methods of new classical economics with Keynesian price rigidities (and the occasional relaxing of the assumption of rational expectations). That encyclopedia article is great, by the way.

Apropos of nothing, this is from the same encyclopedia’s article on fiscal policy:

The greatest obstacle to proper use of fiscal policy—both for its ability to stabilize fluctuations in the short run and for its long-run effect on the natural rate of output—is that changes in fiscal policy are necessarily bundled with other changes that please or displease various constituencies. A road in Congressman X’s district is all the more likely to be built if it can be packaged as part of countercyclical fiscal policy. The same is true for a tax cut for some favored constituency. This naturally leads to an institutional enthusiasm for expansionary policies during recessions that is not matched by a taste for contractionary policies during booms.

Paul Krugman complaining about scholars not reading other people’s work. HA!

Frankly, I don’t feel like writing about this anymore except to register my general dissatisfaction with the recent criticisms of modern macroeconomics. The critics don’t seem to have noticed the progress made in the field in the last several decades.

• Wilkinson – Macro people have been studying social psychology (aka expectations) for a long time. We know something about it. I do agree, however, that we know very little about how fiscal policy affects expectations.
• Kling – I’m sorry you hated your graduate macro class in the 70s. There’s been progress since then. Substantive criticism here.
• Krugman – Fama’s not a macroeconomist so his his writings are a noisy signal from which to glean information about the state of knowledge in macroeconomics and you’re ignoring everything but the first couple of paragraphs of Cochrane’s paper.
• Waldman – Everyone in macro uses DSGE models with imperfect competition and price stickiness. And, horrors, everybody assumes rational expectations except when, of course, they don’t. The freshwater vs. saltwater distinction is moot. The debate is about what frictions matter, not whether or not there are frictions and its certainly not about methodology.
• Wolfers – Did you check to see how many references to “phlogiston” there are in the physics literature lately? Does ideological bias explain this trend? Those bastard right- (or is it left-) leaning physicists! Grrr… the answer is fiscal policy doesn’t F-ing work so why F-ing study it!!!111!!!

This isn’t these critics’ fault, of course. Macro people have been bad at getting the message out.

If you really care about the state of knowledge in macroeconomics, there’s a great set of papers in the inaugural edition of the the AEJ: Macroeconomics journal. I like the Michael Woodford paper the best. It is accessible to everybody.

He claims modern macro is only mathematical masturbation, that its not empirically relavent, it ignores unemployment and the modern consensus was reached in the discipline by ignoring critics. He’s wrong, very wrong, on all counts. Also, he seems to misunderstand the modern critique of macroeconometric models — the so-called Lucas Critique¹.

Macro-theory is math heavy and it has become more so over time. Part of this is pure mathematical masturbation, no doubt, but to a large part this trend is driven by a desire to make explicit all the assumptions that are being made and to more precisely understand the implications of those assumptions.

The need for more math is also related to the increase in the empirical relevance of theory. I’m convinced the only standing legacy of the Real Business Cycle literature, besides method, is its insistence on bringing the models to the data. In modern macro, its simply not enough to identify the existence of some effect or other. For example, real business cycles were relevent because they proved to be quantitatively important… a large chuck of business cycle fluctuations are driven by supply shocks. And RBCs have been supplanted because they didn’t explain enough of the data. The empirical relevance of real shocks couldn’t have been tested without out explicit mathematical models of the phenomenon.

This is what frustrates me about Kling, Krugman, et al’s ad-hoc theorizing. They seem contented to identify that certain macroeconomic features exist, but they don’t bother to quantify the importance of those features. For Kling, he identifies risk preference shocks as important drivers of the business cycle. Fine. How important are they? Well Kling never attempts to answer that question, but these shocks have actually been studied and they’ve been found to be empirically insignificant.

For Krugman, its all about what I call “weak” liquidity traps². There’s no discussion of magnitudes; its never asked just how important is this fact to our present predicament. Interest rates are zero and to Krugman this is the only salient fact about the macro-economy.

Macro has moved on from real business cycles — even if Kling’s criticisms seem not to have — but it has maintained the discipline of bringing the models to the data. Whole books have been written on how to estimate so-called DSGE models.

Time-series techniques have come a long way since Box-Jenkins — VARs and what have you. More importantly, applied theorists use those techniques to test theory. Its rare to find theory papers that don’t have data sections where there’s at least a nominal attempt at testing the implications of the model.

Real business cycles ignored unemployment. True. Modern macro, on the other hand, has been modeling and testing ideas about unemployment for two decades. My own research is a version of a general equilibrium employment search model. Here’s a DSGE model with unemployment. And look at that, there’s even a data section where the model is tested. How about that!

I’d say, if you had the time, you could pick through Kling’s quite good macroeconomic lecture series and find each element studied somewhere in the modern macro literature. Of course, its not his fault that he not up on the recent literature in macro. I’ve made the case that we in the macro field need to do a better job of evangelism. That said, he should be aware that much research has been done since the 70’s and most of it isn’t real business cycles and lots of it touches on the “fundamental issues of macro.”

1. I’m too lazy to write out what he gets wrong about the problem with macroeconomic models. The fundamental problem with them has little to do with the statistical power of the tests used to test those reduced form models, as Kling claims. Basically, Lucas argued reduced form systems of equations didn’t tell us much with making policy because they only reflected averages of past behavior and they didn’t provide understanding of underlying mechanisms. When the underlying environment changes in some fundamental way, like there’s a change in policy, the past correlation between variables may no longer hold. Its a variation on the theme of correlation not being causation. [↩]
2. He defines a liquidity trap as a period of zero short term interest rates. This is a “weak” definition because the concern with liquidity traps is that they make monetary policy ineffective. I’ve mentioned before there’s a quite significant literature that shows monetary policy is not ineffective at zero rates of short term interest. Certainly, routine monetary policy where the Fed and banks swap treasuries for cash is ineffective at this lower bound for interest rates, but routine policy isn’t the only policy tool available to the Fed. [↩]

Others say that we should have a fiscal stimulus to “give people confidence,” even if we have neither theory nor evidence that it will work. This astonishingly paternalistic argument was tried once with the TARP. Nobody could say how it would work in any way that made sense, but it was supposed to be important do to something grand to give people “confidence.” You see how that worked out. Public prayer would work better and cost a lot less. Seriously, as social scientists, economists don’t have any special expertise to prescribe what intrinsically meaningless gestures will and will not give “confidence,” so there is no reason for anyone to listen to our opinions on that score.

— Cochrane

Rodrik observes, as Wilkinson suspected, the margin on which economists are debating the fiscal stimulus isn’t economics. Instead the Krugman vs. Chicago debate is “philosophical, political, and practical–revolving around the role of government, the extent of rent-seeking and public-choice concerns in government programs, and the right mixture of prudence and boldness that the situation requires.”

I’m not convinced. There’s the issue of whether monetary policy is impotent or not given zero interest rates. Krugman says “traditional” money policy — swapping treasuries for cash — is impotent and he’s right. If the policy choice was just between traditional money policy and fiscal stimulus than Krugman would be right about the necessary policy and Rodrik would be right that this was a debate about ideology. Big government types observe traditional money policy is broken and advocate government expansion. Small government types hate that idea and rail against it.

The choice, though, isn’t between traditional money policy and fiscal stimulus. There are a number of papers showing monetary policy doesn’t have to be impotent when we run up against the zero lower bound of interest rates. The ideological battle dissolves (unless you really, really want fiscal stimulus) because with non-traditional monetary policy we’re still talking about huge government intrusion in markets — albeit temporary and reversible. Non-traditional monetary policy has the Fed intervening in capital markets — running them as Cochrane puts it — but this sort of policy is preferable to fiscal policy for a number of reasons outlined in that Cochrane article, but primarily because its much easier for it to adjust to prevent inflation.

In any case, we’re back to fighting over economics.

Gali’s paper is really good. Its the best case for fiscal policy I’ve seen using the modern macro framework. I think the introduction and conclusion are accessible to a general audience and the empirical and modeling sections are good reviews of new Keynesian models and methods for you macro geeks.

Anyway, the model’s innovation is this chart (particularly the increase in consumption due to government expenditure):

From research

The greek symbol lambda represents the percentage of the population that live hand-to-mouth. These are folks that eat everything they earn; they don’t save. The model is agnostic as to why these folks make decisions like this, i.e. limited access to credit markets, myopia, etc. On the vertical access, you see the multipliers implied by each level of hand-to-mouthers. To get multipliers above one — to make government spending worth it — less than 75% of the population needs to be savers. Christie Romer’s multiplier of 1.5 corresponds to having about 40% of the population living paycheck to paycheck.

I’ll leave it to the reader to decide what lambda is reasonable.

What’s the mechanism, you ask?

Rule-of-thumb consumers [wa: i.e. non-savers] partly insulate aggregate demand from the negative wealth effects generated by the higher levels of (current and future) taxes needed to finance the fiscal expansion, while making it more sensitive to current disposable income. Sticky prices make it possible for real wages to increase (or, at least, to decline by a smaller amount) even in the face 29 of a drop in the marginal product of labor, as the price markup may adjust sufficiently downward to absorb the resulting gap. The combined effect of a higher real wage and higher employment raises current labor income and hence stimulates the consumption of rule-of-thumb households. The possible presence of countercyclical wage markups (as in the version of the model with non-competitive labor markets developed above [wa: and represented by the graph above]) provides additional room for a simultaneous increase in consumption and hours and, hence, in the marginal rate of substitution, without requiring a proportional increase in the real wage.

Non-savers don’t save even though they know their taxes will be higher in the future. So when government expenditures increase employment and price stickiness keeps real wages high, the non-savers consume more.

Good stuff.