The CBO says… moooo

I imagine this is how it worked for court alchemists. The CBO says that it has been ordered to give a prediction of the effect the ARRA and so it has.

The Economists suggests this reverse crystal ball gazing is valid because its model driven. Alchemy was model driven: if there is a Philosopher’s Stone, then you can turn copper to gold with it. Hey, alchemists models were even internally consistent; Philosopher’s Stone had the properties needed to make the transfiguration possible. The problem is they weren’t empirically relevant. Despite the evidence from the Harry Potter franchise, it turns out there is no Philosopher’s Stone.

Why is this alchemy? The CBO report talks about uncertainty of so-called “multipliers” as if it was trying put a confidence interval around a fixed, but unknown value. “The ranges between high and low multipliers are designed to encompass most economists’ views about the direct and indirect effects of different policies.” ((BTW, why is “most economists’ views” considered a valid way to estimate parameter uncertainty. Even assuming multipliers are structural and thus throwing 30 years of research in macroeconomics out the window, estimates of multipliers are uncertain because we don’t have sufficient data to estimate them NOT because 3/4 of economists get their estimates of multipliers from Mankiw’s textbook.)) But we know multipliers are not structural, that for different policy and economic environments the multipliers will be different. If we had Sumnerian monetary policy, fiscal multipliers would be zero. If we were in a liquidity trap or if the Fed gave up on monetary policy, multipliers would quite high. By assuming constant multipliers, the CBO is manufacturing the result.

How good are the CBO at forecasting (or hindcasting in this case)? Not good at all. Since 1976 their forecasts have been WORSE than random walk forecasts.

So the King orders copper to be turned to gold and the alchemists comply. The King’s happy. His subjects are happy. Their reality is unperturbed by actual reality.

A neat application of Robustness

Robustness is a fledgling literature in Macro. The primary concern of robust analysis is that we don’t know the exact model of the economy and this model uncertainty has policy implications. Also, the math is neat.

Uncertainty about what the correct model is causes optimal policy to give heavy weight to worse-case scenarios.

Ellison and Sargent found a pretty neat application of robustness. The Fed staff are a bunch of academics who believe they know the true model of the economy. They use the “true” model to make forecasts and those forecasts are usually really good. The FOMC is the policy making branch of the Fed. They take the staff’s forecasts, produce their own forecasts and then set policy. It turns out the FOMC’s forecasts are worse than the staff’s. Those dumb policy makers, right?

Wrong. It turns out that because the FOMC is uncertain about the true model of the economy, they won’t take the staff’s model as the true model. The optimal response to this uncertainty would lead them to worry more about worse-cases. As Ellison and Sargent say, the FOMC “can be bad forecasters and good policymakers”.

The New Expectations Revolution

Sumner writes his manifesto.

In the 70’s they discovered expectations mattered. Since then “expectations are important” has been muttered towards the end of macro lectures but the idea hasn’t sunk in. Sumner wants to make expectations the central concept of the discipline.

Expected future outcomes (like inflation and output) determine today’s outcomes via the capital markets. His big insight is that the capital markets are the best measure of those expectations. The only expectations that matter are the ones that market participants have. They’re the ones setting wage contracts and prices. If market participants have the “wrong” expectations, prices and wage contracts will be “wrong” too and outcomes will be “wrong” anyway.

This means the solution to the business cycle — at least the part caused by nominal shocks — is to change policy so expectations and the target line up. First, the Fed has to convince itself that it can control the nominal level of output. Once they’re convinced, we’ll be convinced by them successfully moving policy to align expectations to their target. Once we’re convinced that policy will always be such that expected outcomes are the Feds target, then it’ll be so and nominal outcomes will be more or less constantly growing.

Good stuff. But what’s next?

This makes me wonder if the Fed has time varying credibility. If real output moves a little bit, the Fed can be expected to do the little that needs to be done to keep nominal output constant. But what happens when there’s a large shock to real output? Will the public believe the Fed will take the extraordinary actions needed to keep nominal output constant? Credibility is earned by the public observing the Fed follow-up on what it says it will do. The extraordinary actions have never been observed before by definition.

Is this what happened last Fall? Perhaps no Fed policy would have been credible under those extraordinary conditions.

*The* lesson from the Great Depression


Because the growth that comes from rising AD strikes our intuition as a sort of “something for nothing” process, we are especially likely to fall into the mistake of thinking in zero sum game terms whenever examining international economic linkages. Common sense suggests that a low yuan cannot help both China and the rest of the world. One country’s trade balance improvement is offset by another’s deterioration. But when you remember that an exchange rate is also a price of money and that the price of money affects both domestic and world AD, things look much different. If during normal times the US suddenly adopted an ultra-tight monetary policy, then the US dollar would appreciate and we’d go into a deep recession. But the rest of the world wouldn’t boom, they’d also suffer an economic slowdown despite the fact that their currencies depreciated against the dollar.

No they don’t

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:

Why do expectations matter?

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?


You can call Federal Reserve policies aimed at the sending of signals that alter the expected rate of future inflation “monetary policy” if you want, but then you lose analytical clarity–because the way such policies work (if they work) is not the “normal” way that “normal” monetary policy works.

Prof. Delong

New rule: to opine on monetary policy you have to have opened a textbook on the subject that was written in the last 30 years.

From Micheal Woodford’s text (in a section in the introduction called “Central Banking as Management of Expectations”):

For successful monetary policy is not so much a matter of effective control of overnight interest rates as it is of shaping market expectations of the way in which interest rates, inflation and income are likely to evolve over the coming year and later. On the one hand, optimizing models imply… behavior should be forward looking… Moreover, given the increasing sophistication of market participants… it is plausible to suppose that a central bank’s commitment to a systematic policy will be factored into… forecasts… Not only do expectations about policy matter, but… very little else matters…

From Carl Walsh’s text:

Macroeconomic equilibrium depends on both the current and expected future behavior of monetary policy.

From Dornbusch, Fischer and Startz’ undergrad text:

You will remember that the nominal interest rate has two parts: the real interest rate and expected inflation… should [a zero interest rate liquidity trap] occur… policymakers are prepared… to pump money into the economy [and thus raise expected inflation].

From Jones’ new (and excellent) undergrad text:

To the extent that policymakers can influence, or manage, these expectations, they can reduce the costs of maintaining a low target level of inflation. This is one of the most important lessons of modern monetary policy… To the extent that the central bank can coordinate people’s expectations of inflation, it can maintain low and stable inflation without the need for [the bank to induce] recessions. Such coordination requires credibility and transparency on the part of the central bank.

From the Encyclopedia of Economics James Tobin says:

While not all monetarists endorse Friedman’s rule, they do stress the importance of announced rules enabling the public to predict the central bank’s behavior… Long rates depend heavily on expectations of future short rates, and thus on expectations of future Fed policies. For example, heightened expectations of future inflation or of higher federal budget deficits will raise long rates relative to short rates because the Fed has created expectations that it will tighten monetary policy in those circumstances.

Yes, Keynes was a smart guy

I’ve mentioned before that I’ve attempted The General Theory on several occasions but have never really “got” it. Knowing Keynes was a smart guy and he basically founded the field I research in, I assume the problem is me not him. Really.

Judge Posner wrote a “Nixon in China” summary of the book which is quite good. Posner says the fundamental tenants of Keynes’ thought are ((Also, he mentions the book’s most important historical context was the persistent unemployment in the UK, not the Great Depression. Embarrassingly, this is the first I’ve heard of that.)):

  • Consumption spending is more important than investment spending
  • Hording leads to the paradox of thrift
  • Animal spirits and Knightian uncertainty

Consumption is more important than investment spending, except, of course, investment spending IS consumption spending only in the future. I’m not sure what to make of this concern in the context of modern dynamic models where a trade-off is made between consuming today and consuming tomorrow. And the idea that consumption drives growth is alien to me in light of all the research in growth that’s happened since Keynes. I guess we can thank him for being the first to tell us to keep our eyes on the ball. Thanks dude!

The paradox of thrift is interesting for two reasons. First, its a case were micro-based thinking gives you wrong answers when you aggregate up. Saving is good unless everyone does it, then its bad and counter-productive. Learning this paradox gives one good instincts about the macroeconomy: the sum doesn’t look like its parts. Second, the paradox is only an issue when prices can’t adjust and monetary policy is ineffective. Thanks again Lord Keynes!

Now for some good ‘ol psychology. Posner says Keynes says investors have “animal spirits” and he, apparently, goes on to commit a fallacy of composition of his own. Its true that investors are frightenable creatures, manic depressive and dumb. I kid. But even if we take this investor psychology as given, its not obvious that it matters in aggregate. Unless these mood swings are highly correlated, crazy investor A’s zig will be matched by crazy investor B’s zag. Just to repeat myself: it is not enough to identify systematic individual psychological biases. You have to show those biases change over the business cycle and those changes are heavily correlated.

Also, I wonder what is meant by animal spirits exactly. Did Keynes mean investors respond to interest rates? That’s uncontroversial. Does he mean risk preferences are volatile? In which case, how important is this effect? This is an empirical question; one needs to model “animal spirits” and quantify their importance.

This leads to my final point. Keynes had tons of insight into the macroeconomy. For that, thanks dude! Its not clear, though, how these insights fit together and its doubly uncertain how they interact with his policy prescriptions. For example, Russ Roberts wonders how animal spirits are impacted by large deficit spending. The only way to answer this question would be to model these effects and see if that model generates data that looks like data generated by the actual economy.

To me the difference between old style, Keynes-influenced macroeconomics and modern macro is this empirical discipline ((This is a nice way of saying THE SALT/FRESH WATER “DEBATE” IS MOOT!!!)). As I’ve said before, its not enough to come up with plausible mechanisms, you have to show how those mechanisms generate the data. Almost every mechanism that the critics of modern macro have come up with, at least the ones I’m aware of, has been tested and has been found to be quantitatively irrelevant.

Posner, and most everyone else, doesn’t like the stories modern macro tells (i.e. exogenous technology and monetary shocks drive business cycles). He likes the stories Keynes told. For what ever reason, quantitative relevance isn’t an important criterion for folks to like a story.

You read this!

If you’re tired of Sumner (how would that even be possible?) and you suspect Krugman is blowing smoke (totally possible), then read this Altig post about the problems with modern macro (which he calls New Keynesian hence Krugman’s smoke).

Altig works for the Fed so he’s tainted, of course, because “real criticism of the central bank has become a career liability”. Real criticism like this and this and this got those guys fired! Oh wait.

(Seriously, read the Sumner piece, too. It compliments the Altig’s piece in a combination that’s a way more serious critique of macro than Krugman’s.)