The Ambrosini Critique

Paul Krugman:

A perfectly standard New Keynesian model, with intertemporal optimization and all that — the kind of model that is standard in freshwater courses — says that under current conditions fiscal stimulus should be very strong… (emphasis added)

The abstract from a perfectly standard New Keynesian model:

This paper argues that if the zero bound on nominal interest rates is binding [and monetary policy is passive], then the government spending multiplier is large.

From today’s WSJ:

Prof. Kenworthy responds to Wilkinson’s essay on inequality and mostly punts. He goes after the idea that consumption inequality should matter and not income inequality. His argument basically boils down to the idea that he doesn’t think we measure consumption well. He’s right about consumption surveys missing outliers like the very very rich because they use random sampling. Also, we don’t include walks on the beach and leisure time in consumption statistics¹. So, like always, we need better data.

Kenworthy’s reply doesn’t address Wilkinson’s main point about the importance of considering underlying mechanisms. He does list some bad things that could, might be, maybe be related to income inequality, but he doesn’t give any reason — besides listing them in a article about inequality — to make us think they are related to inequality.

And in a strange twist, he ends his comment saying the real problem is “poverty” and not income inequality at all:

Imagine an America in which high-quality public services raise the consumption floor to a high level: most citizens can put their kids in high-quality child care followed by good public schooling and affordable access to a good college; they have access to good health care throughout life; they can get to or near work on clean and efficient public transportation or roads with limited congestion; they enjoy clean and safe neighborhoods, parks, roads, museums, libraries, and other public spaces; they have low-cost access to information, communication, and entertainment via reliable high-speed broadband; they have four weeks of paid vacation each year, an additional week or so of paid sickness leave, and a year of paid family leave to care for a child or other needy relative. Even if the degree of income inequality were no less than today and we still had CEOs, financiers, and entertainers raking in tens or hundreds of millions of dollars in a single year, that society would be markedly less unequal than our current one.

I put poverty in scare quotes because its clear he’s not talking about Dickensian/sub-Saharan African poverty, but a relative sort. Its true that I like it better, and apparently so does Kenworthy, when the folks in my community consume at a similar level of quantity and quality as me, but that they don’t isn’t necessarily, in such a rich society, a sign that they aren’t able to do so. People that aren’t me have weird tastes and that drives them to do weird stuff that I wouldn’t do. They’re not poor because of it, just weird. And any case, what does “poverty” or poverty have to do with inequality?

1. Wilkinson actually addresses this issue, if I remember correctly, in his recent policy paper regarding inequality. He shows data that suggests richer folks have less leisure time these days than poor. [↩]

As dictator of the universe, I would force everyone to read the second part of Will Wilkinson’s essay; the part on why mechanisms generating income inequality, not inequality itself, are what matter. This is mostly because I’m writing a paper on one such mechanism and, hey, publicity!, but also everyone should read it because, well, what Wilkinson says is true.

You like truth, don’t you?

Income inequality is one of those topics that makes smart people dumb. When asked why income inequality matters to him, a once proficient and smart (he’s still smart, no doubt) internet commentator wrote on this blog “I don’t really care why, I just do.” A short-circuit of thought: income inequality is bad, QED.

Inequality matters is incorporated into the very structure of the mind ¹.

Alas, I’m not yet the dictator of the universe. Go read that section (or heck the whole thing) anyway. Its not a nitpick of the empirics. Its not apologetics for the status quo. Its not a tired retread of right-wing talking points. At the very least, read it as the most advanced arguments your ideological opponents can throw at you so you might prepare your own counterarguments.

Read it!

1. This line and the post title are taken from this essay. While the choice might be politic, Wilkinson dwells on correctable mechanisms generating inequality like unequal education, taxes or even norms regarding renumeration of CEOs. We should be prepared to confront innate inequalities, too. [↩]

In comments, Mike linked to one of his posts from a couple months ago where he quotes William Easterly:

The most important part of the much-maligned Efficient Markets Hypothesis (EMH) is that nobody can systematically beat the stock market. Which implies nobody can predict a market crash, because if you could, then you would obviously beat the market. This applies also to other asset markets like housing prices.

Mike goes on to describe a paper called The Limits to Arbitrage. Under the realistic assumptions that only big players arbitrage and there is an agency problem where those big traders have information about fundamental prices that the people that hire them do not¹, even these big traders can’t stay solvent long enough. Thus, Easterly’s contention is false.

I don’t see the connection. Nothing in that paper suggest market prices don’t incorporate all available public information. Yes, arbitrageurs know more than the public. If their principals allowed it, they’d make trades on that information, but they don’t so they can’t. There are no profit opportunities.

The intellectual history of the EMH is basically:

1. Fama names the EMH
2. People test EMH making assumptions about asset pricing (e.g. CAPM)
3. Early tests don’t reject EMH, but later tests do
4. Fama observes these rejections are of the joint test of the asset pricing model and EMH… the problem could be with the asset pricing model
5. People try different pricing models and discover there aren’t any good ones (i.e. the joint test keeps getting rejected)
6. The Limits of Arbitrage suggests the problem is with liquidity constraints
7. People again say this is a problem with EMH
8. Cue Fama…

Its funny. I’m beginning to think that EMH isn’t a testable hypothesis. Its a subsidiary hypothesis, like in cosmology the assumption that the physical constants are in fact constant, that makes it possible to test other hypothesis. Without the EMH, we can use any ad-hoc explanation to explain any particular behavior. Under this view, anomalies teach us about asset pricing models and not the rationality of markets.

True, Fama’s work depended on arbitrage having no limits, but it should be easy (as in, not easy at all) to redefine efficiency to include the liquidity constraints of arbitrageurs. Then we can say markets are constrained efficient. I have no idea what this would mean for the allocation of capital in the real economy (the paper points out that the extent of the agency problems vary by asset class but I don’t imagine asset classes are much correlated with “capital classes” or sectors of the real economy). And policy implications?

1. Realistic assumptions, yes, but how sensitive are the results to these assumptions? and how would they interact with other behavioral assumptions (e.g. why did principals hire the agents in the first place)? what happens as the arbitrageur uses more and more of his own money? [↩]

Keep in mind that there’s huge fixed costs to simulations. I wrote code in May that is still running. As in, it hasn’t converged yet. This was suppose to be my job market paper.

This summer was spent trying to find ways to make my code run faster. There’s not much economics in that.

There’s not much economics in the algebra involved in getting analytical solutions to your models, either. But at least the end result is an equation that you can give an economic interpretation to.

Also, my sense is that these sorts of papers take a long time to get published. This is probably because the models are not very transparent. People giggle when I say that my paper will have “simulated comparative statics”.

Also, don’t use R to simulate stuff in. Its really slow and there’s not much you can do about it. Otherwise, R rocks.

I’m teaching finance this quarter. Thumbing through the textbook section on “anomalies” and behavior finance I see cites to lots of papers by these three guys.

These three are my guess for the Nobel. If I didn’t misread the “depression” contract on intrade (I didn’t catch that they summed annualized quarterly numbers to define a depression), I’d have money in that account to bet on these guys.

BTW, I can’t believe Barro hasn’t won.

UPDATE: Cheerleading for EMH. Cochrane’s introduction to Fama gives an argument for why these three folks deserve the prize.

The Real Scientist is breathing down my neck because we need to get out of town for something, but I have to get this out in the universe before I forget:

Talk to your advisors. All of them. They are, all of them, a huge asset. You have no idea which of your papers or ideas will be ready in time for the job market and you don’t know which of your advisors will be most open to your ideas.

Schedule a meeting with every one of them right now and meet with them regularly. Do it!

… this is a very good sentence: “I mean that the academic and esoteric economic theories that are studied in graduate university courses have a very real world and every day practical application.”

I meant to link this last week… but such is life when trying to convince your advisors you’re ready for the job market.

I went after Prof. Delong for having an abnormal view of how normal monetary policy works but I didn’t tell you what the actual non-abnormal normal view was. Prof. Sumner does:

Now consider [a] temporary currency injection. We know that the long run price level doesn’t change. Once the money supply returns to the original level (a year later) prices should also return to the original level. At first you might assume that monetarists would claim that the price level would double, and then fall in half. But consider the real interest rate. Monetarists typically assume that real variables like the real interest rate aren’t much affected by monetary shocks. But if prices doubled, and then were expected to fall in half, the expected real return on currency would be 100% in year two. That is, the purchasing power of money would be expected to double in year two. More likely, almost all of the temporary currency injection would be hoarded and prices would rise by just one or two percent—the risk free real rate of return.

Astute readers might notice that this thought experiment is quite close to the model Krugman used to explain the liquidity trap in Japan…. In fact, monetary policy is not about swapping currency for T-bills. It is about changes in the future path of currency (relative to demand.) Because money doesn’t affect interest rates in the long run, those changes lead… to a change in the future expected price level. And that has an immediate effect on all sorts of asset prices; including stocks, commodities, and real estate. And if wages are sticky (and they are) this also has an immediate impact on employment.

In retrospect, the surprise about the stimulus debate, to me, was that there’s a big chunk of economists that doesn’t seem to understand how monetary policy works, at least from the perspective of research over the last 30 years. In a sense, big chunks of economists were speaking different languages; those speaking modern macro and those speaking… umm… 70’s macro. The frustration in the debate, the heat generated, was derived from the fact that both chunks of economists didn’t realize they were speaking different languages.

Which begs the question: what the hell chunk did Krugman belong to?