The Ambrosini Critique

Japan bashing is popular. Looking at the data since QE started:

Real per capita GDP has risen 1.4% a year and yet prices have been constant.

I’m not sure why any one inflation target (positive or negative) is better than any other¹. In any case, the level of the target is of second order importance to having stable inflation (and thus stable inflation expectations and thus having a target). The costs of discretion are much larger than the costs of minimal inflation (or deflation).

1. Woodford chapter 7 argues a target that tends to zero is optimal or a target that has expectations of inflation tending to zero is optimal. [↩]

When you first take a grad level economics class, it occurs to you the discipline appears to be “social physics”. Where you thought the discipline was “a tool for understanding and social criticism and an instrument for intellectual enlightenment” you begin to suspect its “a tool for social engineering and an instrument for progressive politics”. The suspicion morphs into a full blown conspiracy theory when you learn the math behind the welfare theorems.

But look at how normative analysis is actually done in economics. Consumers of models compare their intuitions about how policy should work against the prescriptions of the model and use this difference to evaluate the model. “Wow, this model says money is too loose right now. I know that’s wrong, why does the model get it wrong?”

One of the reasons to reject real business cycle models is because they provide no room for macroeconomic management. The dissatisfaction with exogenous growth models is that they’re silent about institutions. There’s a heavy bias against models of wage inequality that rely on transient features of workers; the problems *must* be structural. Unemployment must be responsive to aggregate demand manipulations and so they can’t be a result of real frictions. And so on.

Despite these examples, after a couple years of doing this, I’ve come to believe that this is an acceptable way to evaluate models. There is no THE MODEL of the economy and our intuitions are basically trustworthy when it comes to social arrangements. Our intuitions are data. If a model gives counterintuitive policy implications, it bears the burden of showing us why our intuitions are incorrect.

Why is it always assumed that “philosophy” or “pictures and talk” are substitutes for mathematical analysis? I mean, they’re compliments right?

• Monetary policy and unemployment: welfare costs of lagged unemployment and optimal policy
• Time consistent fiscal policy: the case for an independent fiscal authority
• Banking crises cause monetary shocks: evidence from an IV
• Monetary shocks cause banking crises: evidence from an IV
• Macroneuroeconomics: detecting expectations shocks in real time
• Modern macro made simple: a new approach to teaching macro

(PS – My own dissertation would be on the list… except I’ve already read it!)

Data analysis!

Right on the front page. The price level has been accelerating (increasing at faster rates) since last fall:

and output is increasing:

and unemployment is not increasing:

The Fed made a mistake last year. No doubt the Fed chairwoman 70 years from now will give a speech admitting fault for the “Great Recession”. Fine.

It does NOT follow from this that we need more aggregate demand stimulus now. Obvious, right?

Now, unemployment is high. Empirically, we know two things about unemployment. It goes down when output is increasing (the so-called Okun’s law) and it lags output. We have increasing output and inflation. If those empirical regularities rear their ugly heads this time around, we know that unemployment will decline eventually, too.

Politically, I get why presidents react to bad-sounding headlines and hold “job summits” when unemployment goes above magic numbers. I don’t get the argument from economists for more stimulus. What theory, what mechanism of lagging unemployment would suggest we need increased stimulus even though output and inflation are rising?

I can think of a few things:

1. Laid off workers are just waiting to be rehired by their former employers
2. There wasn’t enough stimulus and we’re moving towards long-run equilibrium too slowly
3. Variant: policy makers were too concerned about inflation and they should put more weight on unemployment going forward

It seems the internets are discovering the fact that this recession hasn’t been characterized by a large number of job losses. Instead, unemployment has been increasing because its harder for people who would have lost their job anyway to find new jobs. The JOLTS data, in other words, suggests that even in the recession laid off workers weren’t temporarily let go. They were fired and no amount of stimulus will get their old employer to hire them back. I’m willing to wager most fired employees have no expectation that they’ll be rehired by the same employer that fired from. In fact, I’m looking at data that suggests they shouldn’t even expect to be rehired in the same occupation; they’re going to have to go out and acquire new skills and find a whole new line of work.

Number one is bunk. What about number two? The problem with the “recovery is too slow” argument is that we don’t know what “too slow” means. Looking at the model I shared the other day, even under the optimal policy that makes the proper trade-off between unemployment and inflation, it takes two years to get half way back to normal unemployment rates. If you believe in the “too slow” theory, then you have to write down a model that would generate faster decreases in unemployment (and not just increases in inflation).

Number three? According to the Gali/Blanchard model, if the Fed is heartless and only cares about inflation, then unemployment is much worse at the time of the shock. This is true. However, as the first graph I showed indicates, the decline in unemployment is much faster. From the peak of unemployment it takes less than two years for unemployment to get half way to its normal level.

Under the third scenario, you might say the Fed should switch to the optimal policy. It should put more weight on unemployment and so it should ease policy. Well, according to the Taylor rule that approximates the optimal policy in the Gali/Blanchard model, interest rates should be about 0.5% 0%. Even under optimal policy where both inflation and unemployment are targeted, no further easing is necessary (and current policy might even be slightly inflationary).

UPDATE: as always I got my arithmetic wrong… post updated with strikes to show what changed.

Blanchard and Gali (2008) incorporate unemployment into the standard model. They have some interesting findings, but this one stuck out:

This is the response of the unemployment rate over time to a 1% decrease in productivity of the economy (a “real” shock) WHEN the Fed has a inflation-only target (i.e. it doesn’t care about unemployment). Blue is the response in the model when its calibrated to look like the American economy and red is the response when its calibrated to look like Europe. Unemployment keeps increasing after the shock for a couple periods and then gradually declines. Look familiar?

Here’s the same graph but for when the Fed has the *optimal* policy of targeting a weighted average of inflation and unemployment:

Unemployment still jumps but it doesn’t have the hump shape. More importantly, notice how little the unemployment increases when the Fed is following optimal, or best, policy… almost an order of magnitude difference in the response of unemployment.

What does this mean? This paper gives us two ways to interpret what happened since last Fall. One, there was a small to medium sized real shock but because the Fed cares too much about inflation, unemployment sky rocketed. Reality looked (and looks) like the first graph. Or two, the Fed is following optimal policy but there was a huge real shock. Our reality is more like the second graph, but amplified.

Ironically, those making a bunch of noise about banking regulation, centering the blame for the recession on the financial sector, are arguing for the second graph. My impression is that those people are also more likely to be agitating for more aggregate demand policy. The second graph has the Fed acting optimally, i.e. there’s no need for further stimulus because the Fed is doing everything necessary. If you buy the logic of this paper, however, you can’t have it both ways.

PS – This model also has a positive response of inflation to the real shock. Given we saw a negative response last Fall there’s still room for a monetary shock in the story.

The problem with most stories is that they’re just words. With just words its easy to sound like you’re making sense, that the one thing you said leads to the other. For example, Ryan Avant says we need more stimulus and so does Scott Sumner (e.g. ?).

So, we have increasing inflation and GDP. Understanding the limited ability of policy makers to fine tune the economy, what model under conditions of increasing inflation and increasing GDP recommends more stimulus?

Speaking of which, I’m embarrassed to say that I have no idea why unemployment is a lagging indicator, but I do know that it has been so for a long time. This means high (but decreasing?) unemployment isn’t necessarily an indicator of insufficient aggregate demand.

The problem with academic macroeconomists is that they’re terrible at telling stories. We say recessions are caused by real and nominal shocks and people snore. And monetary policy is too boring to be the best aggregate demand policy.

“You mean to tell me that buying and selling some debt instruments is the key to solving all of our problems. What, no knight in shining armor riding down from Capital Hill to save us? No brilliant grand plans from genius economic advisors in the White House?”

When I taught the Great Depression this summer, you could see the disappointment on my students’ face when I told them that bad monetary policy was the primary cause of its depth and breadth. They wanted epic stories about Wall Street versus Main Street, evil cabals of foreigners or bumbling Presidents. A student dropped the course when he realized the monetary policy explanation didn’t involve a conspiracy of bankers but just the Fed’s legitimate misunderstanding of the role of money in the economy. He told me “this class isn’t teaching me real economic history”.

Arnold Kling says recessions are caused by Great Recalculations, credit cycles and monetary fluctuations. He talks of great showdowns like “folk-Minsky-ism” v. “folk-Keynesian-ism” or academics v. policy makers. He tells good stories.

As far as I can tell, though, his stories map completely onto what he calls the scholarly consensus in monetary economics. Recessions, including this last one, are caused by real and nominal shocks.