This was a funny exchange between two pretty well known economists:
SCHRAMM: Question here.
LUCAS: Uh-oh. (Laughter.)
QUESTIONER: Ed Prescott, Arizona State University. There’s one area I’m a little bit confused. there seem to be that a little shuffling of assets — you know, I own a little bit less of some, a little bit more deposited in the bank’s going to make much of a difference at all. There’s plenty of assets out there for the transaction purposes and it just A goes up and down; B goes down and up on the two assets.
LUCAS: What do you mean by asset?
PRESCOTT: I don’t see how the money does anything real.
LUCAS: What do you mean there’s plenty of stuff out there? Like we could all sort of start trading in gold?
PRESCOTT: I’m saying that I — when the Fed gets my junk bonds, and I get deposits in my bank, where’s the — it’s just changing my portfolio a little bit, changing the Fed’s a little bit, and I guess our banks — and my bank’s portfolio. These are all — there’s nothing real. They’re just bookkeeping entries, I mean, sort of shifting assets around.
LUCAS: Shifting assets around when liquidity’s involved — I mean, is seems like what you’re saying is that Lehman Brothers couldn’t have failed. Liquid assets have the property that — I hold them because I know I can pass them on to the next guy. Why does he take it? Because he knows he can pass it on to the next guy. And that’s true of U.S. currency, I’m going to go take my money into Walgreen’s, you know, and get in an argument about whether or not they’re going to accept it or not.
But all these probably created liquid assets seem to me to be analogous to kind of unregulated money or private money — used to be called inside money. And it does matter.
I’m not sure about the Lehman example. If you wake up in the morning and all your assets are worthless (as in they’re not productive), the problem isn’t that you can’t sell them. Not finding some sucker to buy them is an indication that they’re not worth that much.
Anyway, I’ve been doing this grad school thing for a while, studying macro, and I’m still not sure if money (policy or nominal fluctuations) has real effects or not.
This long Sumner post is well worth it. My favorite part is all of it but bloggy customs require an excerpt:
The intuition is that if the Fed always targets the forecast, and if Fed forecasts are pretty close to the consensus private sector forecast, and if the Fed never targets an NGDP growth path which is expected to generate a recession, and if recessions are avoidable right up to the moment they begin, then recessions will never be predicted by the consensus forecast. It may seem implausible that recessions are avoidable right up to the last minute, but recall that the recession that began in December 2007 saw positive real GDP growth in the first two quarters of 2008. A highly expansionary monetary policy in mid-2008 might well have prevented a downturn in the second half, and the first half of 2008 might not have been retrospectively labeled a recession. Recessions are not just downturns, they are prolonged downturns, and hence are preventable even after they have started.
Despite that fact that we teach our students out of textbooks that suggest the zero lower bound doesn’t prevent highly effective monetary stimulus, and despite the many foolproof escapes from a liquidity trap put forward by Bennett McCallum, Lars Svensson, and even Ben Bernanke himself, there never in fact was any kind of consensus that the zero bound did not inhibit monetary stimulus. The profession as a whole is just as afraid of a liquidity trap as was Keynes, maybe even more so.
The argument is that policy makers had it all figured out, resulting in the the 20 beautiful years of the Great Moderation, but lost faith when interest rates hit zero.
By screaming about liquidity traps, Paul Krugman caused the recession!
I don’t know by what mechanism expectations are set. Conditioned on this mysterious process connecting Fed policy and the public’s expectations, people should know the Fed plans to keep interest rates low for a long time. This probably means they will be low even after recovery starts and that definitely means there will be inflation.
Got that you public? There will be inflation, damn you! Hey you over there socking cash under the mattress: cash will be worth less in the future and your better off investing it. Seriously. The Fed is dead set about making that cash worth less!
Now, credibility sets in, bringing about recovery. I’m holding my breath.
(PS – Prof. Sumner, Fed GDP forecasts are nominal targets. Forecasting is the only credible way to create targets.)
UPDATE 5am – Ooops… See how easy it is to condense all types of monetary policy into “interest rates”!
You’ve heard before that Christie “I heart fiscal policy” Romer wrote a paper claiming monetary policy ended the Great Depression and that it ends recessions in general. I thought this criticism of the latter paper was interesting:
Romer and Romer completely ignore all of this literature. There is not a mumble of an apology in the direction of Tobin and Solow’s methodological concerns, much less their formal statements by Sims and others. Despite its fundamental importance for identification, there is not a hint of a reference to monetary theory, even David Romer’s thesis or the collection of papers in his book with Greg Mankiw (1991). The empirical findings of the huge VAR literature go unmentioned (with one lonely exception). The paper reads as if Romer and Romer are the first to ever examine recognition, decision, and action lags at the Federal Reserve.
The underlying economics, like the empirical methods, is straight from the 1960s: The paper does not ask whether the economy returns to a natural rate without policy intervention; the 1970s challenge that systematic policy might have no real effects is not even dismissed, to say nothing of the 1980s challenge from stochastic growth models that not even the beginnings of recessions need policy shocks.
The omission is so glaring it must be intentional. Here is my — quite sympathetic — interpretation. The last 30 years of macroeconomics are difficult, and the period hasn’t provided firm answers to the earlier questions. VARs address Tobin and Solow’s criticisms, but lots of problems remain. One has to identify shocks from the residuals, consider the potential effects of omitted variables, and worry about whether the AR representation, MA representation, or some combination is policy invariant. Identification isn’t easy. The empirical results are sensitive to specification; the standard errors are big, and one ends up with the impression that the data really don’t say much about the effects of monetary policy-which may in fact be true. Theoretical models seem equally sensitive to assumptions and do not connect easily with empirical work.
We’ve been at this over 30 years, and look how little progress we have made toward answering such simple questions! Can understanding monetary policy really be so difficult? Why don’t we just throw all the formal methodology overboard and go read the history of obvious episodes and see what happened? If, like me, you have struggled with even the smallest VAR, this approach is enormously attractive.
Perhaps this is Romer and Romer’s motivation. But if so, I think that Romer and Romer are falling into the same trap that ensnared the rest of us. Perhaps they started with a desire to just look at the facts. But then they wanted to make quantitative statements. How much would output have changed if the Fed followed a different policy? To do so, they reinvented the St. Louis Fed approach-an econometric technique. Despite the desire to “do something simple” (David Romer, during the discussion), they in fact evaluated policy from the autoregressive representation of an output-fed funds VAR. Now they face Tobin and Solow’s classic causal and identification problems, which cannot be addressed by quotes from FOMC meetings.
Adam and Eve in the garden of Friedman, they have taken one bite of the forbidden econometric fruit. But the serpent (me) is still there, whispering “go ahead, just add a few more variables;” “you can fix that, just put in a Fed reaction function;” “Why don’t you write down a few structural models and verify what your regressions are picking up?” I don’t see how they can resist taking bite after bite, until they are cast out of the garden, explicitly running VARs, and working hard for identification with the rest of us.
This sounds like the dialog in my head when I’m reading Prof. Kling. Then there’s this line: “VAR methods did not evolve as recreational mathematics. They evolved as the best response a generation of talented economists could come up with to genuine and serious concerns.” The same goes for DSGE models and modern theory. Macroeconomics is difficult and its frustrating that we don’t know more.
My favorite paragraphs:
The key insight of rational expectations (which should be called consistent expectations) is that if you model the economy in a way where policy X produces result Y, you should not assume the the rest of the public believes policy X produces result Z. This is especially true of public policies. It is very unlikely that a policy regime will be effective if it is based on the assumption that the public will respond foolishly to your policy. They might behave foolishly, but you can’t count on it.
The rational expectations revolution also showed that:
1. Today’s AD will be heavily influenced by changes in tomorrow’s expected AD, and thus by changes in the expected future path of monetary policy.
2. Changes in the expected future path of policy show up immediately in the auction-style commodity, stock, and bond markets.
The idea is the world is classical in the long run (permanently doubling money, doubles prices), but prices are slow to adjust in the short run. Some prices adjust faster than others so today’s GDP can change in response to expected future changes in monetary policy. So even in a weak monetary trap (where short-term rates are zero) if the monetary authority can affect expectations, they can have an affect on GDP.
The predicate — “if the monetary authority can affect expectations” — is where the disagreements are. Krugman thinks normal open market operations are the only mechanism for the Fed to affect expectations. Most everyone else thinks otherwise. Read the rest of the Sumner article to get six reasons to think Krugman is wrong.
An old joke about Real Business Cycles is that they assume recessions are caused by technological regress. Without other frictions, the only way for an economy to get lower output given the installed capital and the number of workers is to have a sudden drop in productivity of those inputs.
Well, who in the hell ever heard of a technological regression? What, did people forget how make stuff? lose the blueprint? Ha ha ha… those stupid RBC theorist. What a bunch of mathematical masturbation!
Ahem. Well, here are three examples of technological regress. First, the financial mess can be seen as throwing sand in the works. Its harder to get working capital — if your bank is skittish you have to walk down the street to get your loans from somewhere else — so production is more expensive. Second, here’s Willem Buiter entertainingly complaining about centralization causing technological regress. Third, an increase in distortions in the finance sector where it is harder for some sectors to get financing can *look* like technological regress.
The last point was explained by Prof. Kehoe at the loooooooooooooong session on monetary policy at the AEA meetings (see day two part 1). He shows a simple single sector growth model with plain vanilla productivity shocks (i.e. technological regress) is observational equivalent to a more sophisticated two sector model with sector specific labor costs (e.g. costs in working capital). The more sophisticated model tells a story for why there is “technological regress” but it doesn’t necessarily tell us more about the economy. For that, the model would need to generate other testable predictions.
The RBC literature found “technological shocks” were important for explaining business cycles. Many, perhaps more conservative, economists took this result literally… variation in stuff policy makers have no control over, namely exogenous technology, cause business cycles so policy can’t help smooth cycles. For this literal interpretation of “technology shocks” those economists were rightly ridiculed, but the lesson of RBC models is exactly what it should be: these models identified a fundamental cause of business cycles and they pointed the way to a deeper understanding. To understand business cycles, we need to understand “technological shocks”. RBC models aren’t wrong; they’re just not right enough.
This post referencing an article by Prof. Delong makes me think people are talking past each other.
Delong and compatriots say that monetary policy has failed and so fiscal policy is necessary. They then mention things about how people are suffering and how we need to alleviate that suffering. They don’t go this far, but at least rhetorically they connect fiscal policy with reducing that suffering, as if its the only way to do so.
Barro et al say monetary policy hasn’t run out of steam and traditional fiscal policy is ineffective. The later point is irrelevant to the economic debate, but key to the policy debate. There are some “untraditional” fiscal policies that would act to improve expectations of inflation. Also rhetorically, at least, these folks are concerned about smoothing out the business cycle.
The thing is smoothing the business cycle and alleviating suffering are the same thing. We all share the same goal! The weird thing is, if you sat everyone around the table, they’d all agree the best way to smooth the business cycle (and alleviate suffering) is to have a constant level of inflation and the best way to do that is to have constant expectations of inflation.
The honest to god dispute is which policies will bring about constant expectations of inflation. Right now traditional monetary policy isn’t workable. The options are non-traditional fiscal stimulus (e.g. “helicopter drops”), quantitative/qualitative easing or both. The policy we’re seeing is traditional fiscal stimulus and tons of qualitative easing.
My take on the stimulus package is that it won’t be very helicopter drop-ish ((and I suspect this fiscal policy may actually slow down recovery by slowing down sectoral shifts, but that’s pure speculation)). Our real hope for recovery is in the untraditional monetary policy being pursued by the Fed. So far, contra-Delong, I think its working given indicators of inflation expectations, though, I’ll admit these measures of expectations are very noisy.
Will Wilkinson is “extremely suspicious of what strike me as intellectually contentious, ad hoc interventions into the economy aimed at expectation management.”
He should be suspicious because when policy makers have discretion, outcomes are worse. This is because people know the government can cheat by trying to exploit short-term trade-offs between outcomes and inflation. Because the government has discretion and they can cheat, people expect governments will cheat and increase inflation — by spending a bizzilion dollars for example — thus increasing their expectations of future inflation. This high expected inflation translates to actual inflation and thus a worse outcome.
On the other hand, if policy makers can commit themselves to a particular policy and that commitment is credible, expectations of inflation are lower, actual inflation is lower and outcomes are better.
How do policy makers credibly commit themselves to policy rules? Well, they don’t increase spending by almost 10% of GDP willy-nilly. Better is to have over 20 years of policies that lead to stable levels of inflation. Too bad we’re going to get the former and no-longer have the latter.
(Lectures 11-14 here are a pretty good and thorough introduction to these ideas. I just found it from googling so there may be something better out there.)
To be honest, I’m having a hard time parsing this post by Arnold Kling. He talks about issues with “structural models” in macroeconomics, but I’m not sure to what he’s referring. Of course models reflect how somebody thinks the economy works. The key is whether or not you can falsify that model. Kling goes on to make is statistical power critique (I think), but I think this misses the point.
Models in modern macro are falsifiable. I know this because I’ve seen some falsified in the literature (this is the whole game!), I’ve been in seminars where a new model is dismissed by some in the audience because it “explains too much” and macroeconomists have developed clear criteria for evaluating models.
A model needs to reproduce time-series data that have statistical properties similar to data generated by the real economy. This often means standard deviations of income, consumption, investment, etc generated by the models match standard deviations in real data. Macro folks also look at how the model reproduces correlations between these data.
An example from recent literature might help. So there’s these new Keynesian models with sticky prices and imperfect competition that predict inflation will spike as soon as a technology shock happens and then peters out over time. The problem with this prediction is that inflation doesn’t react this way to technology shocks in the real economy. A number of empirical studies with a number of different so-called identification assumptions (maybe this is what Kling has problems with?) have found that inflation doesn’t spike right away after a shock. It takes a few quarters for inflation to hit its peak before it then peters out. Macro people affectionately call this “hump shaped” inflation.
This as seen as falsifying the simply new Keynesian model ((Falsifying in the same way the motion of Mercury falsified Newtonian physics. Newtonian physics still does a pretty good job; I’m mindful of walking under trees dropping their fruit. Relativity just explains more facts than Newtonian physics does.)) . And people have been working on alternative models that generate hump shaped inflation. (If you ask me, the issue was successfully resolved in this paper by one of my former teachers.)
Krugman estimates a Phillips curve thus solidifying my belief that he, along with Kling, doesn’t know modern macro.
There is no structural relationship between output gaps and inflation. The correlation he estimates means nothing. Nothing. Certainly, you can’t, as he does, read off the chart future inflation rates using estimates of output gaps.
Expectations of inflation matter. We don’t know what expectations of inflation are because being expectations they’re in people’s heads. We can get some hints at what expectations are by looking at markets where people bet on future inflation rates ((Annoyingly, the Fed has stopped publishing statistics that translate the prices in these markets to a measure of inflation expectations. Not sure why they’ve postponed this analysis when it would be really, really nice to have it. Krugman, strangely given this recent post, looked at similar data a few weeks ago. He, of course, declared inflation expectations to be tanking, threating deflation. The problem with just comparing the TIPS rate and the treasury rate, like Krugman does, is there’s a liquidity premium. People will bid up the price of a bond that has a thiner market. Those two markets may have different premiums or the premium might swamp out differences in these rates due to inflation expectations. Greg Mankiw says using TIPS data to understand deflationary expectations doesn’t work because the payoffs on those bonds is asymmetrical. Anyway, while I suspect TIPS data is a squirrelly measure of expectations, I wish someone could explain this stuff to me.)). Another source of information about expectations is surveys of inflation forecasters (industry economists and the like). A recent paper by Mankiw, Reis and Wolfers looks at these data over the last few generations. Also, here’s some measures the Fed uses to get a sense for what people expect to happen to the price level. Notice “real” interest rates are positive which isn’t consistent with a Krugman’s definition of a liquidity trap (or what I call a weak liquidity trap).
Anyway, there’s no reason to think looking at historical inflation rates will tell us anything about what people expect future inflation to be. I think this is doubly so given the break down of traditional monetary policy. People won’t necessarily believe the Fed has as much control over inflation as they usually do. This goes for profession forecasters, too. They may not be so good at their job these days.