The extent of our knowledge

One of the reasons I think modern macro is successful is that it cleanly separates what we know from what we don’t know. Making assumptions about how people make decisions and assumptions about how those decisions interact, modern macro models give expected behavior. In our models we capture all that we don’t know in what are called “exogenous shocks”. They’re “exogenous” because they’re outside the model and they’re “shocks” because they’re exact value is unpredictable even if the economic agents inhabiting the model’s world knows their distribution.

Given the behavior of exogenous shocks and the predicted behavior of the model’s agents to those shocks, we can take the output of the model and compare it to real data. If a model replicates real data then its assumed this is due to the assumptions about shocks and behavior. Because the shocks represent things we don’t know, we’d like to have the most simply shocks possible and therefore have the structure of the model explain as much of the data as possible.

Similarly, we can compare models by seeing which explains the most patterns in the data (or at least the patterns we care about) using the same exogenous shocks. If one model explains more data, we say that one tells us more about whatever is being studied. The shocks, however, continue to reflect our ignorance.

I like this paper by Eggertsson (h/t EotAW) because it shows how important the assumptions on exogenous shocks can be. Cole and Ohanian have several papers (findings summarized here) that show New Deal policies (by which they and Eggertsson mean industrial and union policies increasing monopoly power) were contractionary. This is actually the standard view that follows from microeconomic theory.

Eggertsson shows that after you include some standard modern macro model features (e.g. sticky prices, monopolistic competition) and you change the assumption on the exogenous shocks, these New Deal policies are, to my surprise, expansionary. The reason is at the zero lower bound for interest rates, without these policies, expectation for inflation doesn’t materialize and the economy falls into a deflationary spiral. When the government gives unions and big companies monopoly power, on the other hand, people expect those unions and big companies to use that power to raise prices. In this way, New Deal policies take over traditional monetary policies roles in setting inflation expectations.

But I really, really like the paper because it makes explicit that the reason its results are different from standard results from Cole and Ohanian is because of the assumptions about the shocks. In both sets of research, the shock is to preference for precautionary savings (“animal spirits”). Cole and Ohanian assume the 1929 crash and the bungles of Hoover were the exogenous shock and when Roosevelt took office that shock began to dissipate. Eggertsson, though, assumes the shock persisted through the great depression. Which is the right assumption, nobody knows.

The paper has very nicely separated what we know from what we don’t know. This makes task for future research very clear… what were the nature of those shocks to animal spirits?

To me, this strand of modern macro literature is encouraging. Everyone’s assumptions are laid out on the table, theories are making heavy contact with data and progress can easily be identified. Its almost like this is science.

What are people pessimestic about?

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?

Multiple multipliers

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.

Political affiliations of modern macroeconomists

Will Wilkinson has words for macro economists. He got me thinking about the political affiliations of macroeconomists. Here’s what I’ve found:

Macroeconomist’s name IDEAS rank Political affiliation Views on fiscal stimulus
Robert J. Barro 3 Republican?, no political appointments Tax-cuts not spending
Robert E. Lucas 5 ? Con, but concerned about sudden drop in consumption
Edward C. Prescott 7 He signed a statment opposing Obama’s tax/trade policy ?
Martin S. Feldstein ((Feldstein has a short NBER paper on fiscal policy (with no model) and he’s also written against Ricardian equivalence but he doesn’t usually write on macro stuff.)) 8 “conservative” Pro, likes military spending
Daron Acemoglu ((Technically Acemoglu is a growth economist, but he writes about everything. EVERYTHING.)) 10 ? Con, worries about long term consequences
Olivier Blanchard 13 ? Pro
Mark L. Gertler 14 ? ?, but he says monetary policy can still be effective
Thomas J. Sargent 17 ? Con
Lars E. O. Svensson 21 ? ?, but has written on the effectiveness of monetary policy when interest rates are zero
N. Gregory Mankiw 22 Republican Con
Jordi Galí 25 ? ?, his research is the only legitimately modern macro that shows fiscal stimuls can work
Ben S. Bernanke 33 Republican appointee His public statements are Pro, but I’m not sure what his private opinions are. His research is all money all the time.
Michael Woodford 34 ? ?, but in a survey has said the consensus is “fiscal measures are not suitable for accurate ‘fine-tuning’, even if it is not agreed that they have little effect.”
John B. Taylor 49 Republican appointee Pro, but has shown the recent tax rebate was ineffective at stimulus

It seems most macro folks are conservative or Republican. The Gali paper on effective fiscal policy seems like it might be worth taking a look at.

You’ll notice Delong and Krugman (and Alesina, Becker, Cochrane, Fama, Murphy, and Zingales) are missing from this list of MACROeconomists. This is because they are not macroeconomists.

It seems to me the historians were calling the finance people boneheads for their ideas on macroeconomics. I wonder what the planetary scientists think about the exobiologist’s views on theoretical cosmology.

Liquidity trap? part II

From Japan 2008

This one needs a caption: There was a sign describing this construction project as building a fish spawning pathway. As you can see, they’re tearing out the old fish spawning pathway to build this new one. I should mention that the government agency that funds such projects had its prefecture headquarters across the street from the construction.

We were in Japan for 21 days and I’d say, besides the usual “Japanese” stuff, the thing that struck me most was the number and size of infrastructure projects, e.g. bridges, dams, railroads, etc.

We got lost driving in the middle of nowhere one day on a one lane road winding through the mountains. In 30 or so kilometers we drove through two or three villages with a total population of at most 100. Along that route there were three major infrastructure projects — realigning the road, erosion control, a new bridge — that must of had budgets in the tens of millions.

In other news, the Japanese government just approved a $132,000,000,000 stimulus package.

Paul Krugman is really smart

Clearly. My salary doesn’t depend on not understanding Keynes and the wonders of fiscal policy. I choose to think this is just a really complex issue and only Nobel Laureates (or some Nobel Laureates) can understand it.

In Krugman’s book, he tells the story of the Capitol Hill babysitting co-op. Co-op members can do three things with their time: babysit others’ children and build up their savings of the IOU coupons they earned, spend coupons and go out for the evening, or sit at home with the kids.

Also, they can borrow coupons, paying interest in the form of more coupons paid back than borrowed, from the co-op authority. This allows the authority to cool off an over-babysat economy by increasing the number coupons that would have to be paid back by those that borrowed them. This means babysitting today is worth less than babysitting in the future so people are more likely to have their kids babysat today. Likewise, a depressed, underproducing economy could be encouraged by decreasing the number of coupons that borrowers would have to pay back.

A liquidity trap comes when the co-op authority reduces the “interest rate” such that one coupon borrowed is paid back with one coupon but the economy is still depressed.

The solution is inflation. Make the coupons people are holding worth less over time so they become less likely to horde them. Penalize liquidity preference.

Thus have inflationary monetary policy.

But then Krugman has another thus. Thus, he says, have the government produce large amounts of deficit spending.

I don’t get it — maybe I need to be on someone else’s payroll or win a Nobel prize. Yes I know about Keynesian crosses, but the government’s borrowed money, besides the usual crowding out by its effects on interest rates, has to be paid back. In anticipation for when those debts come due, people save more today so they can pay those future taxes; they horde babysitting coupons. In that case, we’re back to where we started. The reason for hording has changed, but the hording remains.

But forget Keynes and hocus pocus theory. The data are pretty inconclusive about fiscal stimulus ((My nomination for best footnote of the year is the third one in the Mountford paper Mankiw cites. One finding of that paper is that consumption doesn’t change much, and so neither does welfare, when there are increases in government spending even if its deficit spending. The footnote says this can be true because of increasing returns, the interaction of sticky prices with “non-Ricardian” agents or with imperfect intersectoral capital mobility.)). Although, Krugman might argue the papers Mankiw cites look at the wrong data, i.e. they look at the U.S. in non-depression times.

I don’t think appeals to the precautionary principle get us anywhere. Yeah, fiscal stimulus might help, but it might hurt too. Creating frictions in the labor market (by increasing unemployed workers’ reservation wages, thus increasing the time it takes them to find jobs) and otherwise slowing down the adjustment of factors of production (by subsidizing dying industries or funding make-work programs) in a time when adjustment is necessary will only prolong the pain.

Delong on Krugman

Frankly, I’m confused by this Krugman post so after I’m done writing this, I’m going down to The Avid Reader to pick up Krugman’s latest book. I suspect he lays out this argument more fully there.

Delong reviewed the original version (written in the late 90s) and had this to say about Krugman’s policy advice:

The core of Krugman’s book is made up of analyses of the two greatest economic disasters of the 1990s: the lost decade of economic growth in Japan, and the waves of currency crises and depression that have rolled around the world … These are the parts of the book I love.

Krugman’s analysis of how the Japanese economy entered its present period of stagnation is lucid, clear, and accurate. The collapse of the financial bubble of the 1980s depressed consumption and investment spending…

The answer to what you should do in order to recover from such a state of depressed aggregate demand is “everything.” You should have the government run a substantial deficit … You should have the central bank push the interest rate it charges close to zero (to make it very easy and cheap to borrow money). And if that isn’t enough you should–as Krugman advocates–try to deliberately engineer moderate inflation. If demand is depressed because people think investing in corporations is too risky, change their minds by making the alternative to investment spending–hoarding your money in cash–risky too by having a share of its real puchasing power eaten away every year by inflation.

So far Japan has changed its fiscal policy to run big deficits (but, as any student of the Great Depression would suspect, they haven’t been big enough). Japan has lowered its short-term safe nominal interest rates to within kissing distance of zero. But these haven’t done enough good. And so Krugman thinks it is time for the deliberate engineering of inflation to extract Japan from what economists call its “liquidity trap.”

But at this point Krugman doesn’t have all the answers. For while the fact of regular, moderate inflation would certainly boost aggregate demand for products made in Japan, the expectation of inflation would cause an adverse shift in aggregate supply: firms and workers would demand higher prices and wages in anticipation of the inflation they expected would occur, and this increase in costs would diminish how much real production and employment would be generated by any particular level of aggregate demand.

Would the benefits on the demand side from the fact of regular moderate inflation outweigh the costs on the supply side of a general expectation that Japan is about to resort to deliberate inflationary finance? …

And there is another problem. Suppose that investors do not see the fact of inflation–suppose that Japan does not adopt inflationary finance–but that a drumbeat of advocates claiming that inflation is necessary causes firms and workers to mark up prices and wages. Then we have the supply-side costs but not the demand-side benefits, and so we are worse off than before. Something like this happened to the Popular Front government of Leon Blum in France in the late 1930s.

Thus senior officials of the U.S. government have a problem… Quiet whispers … will not … have much influence on what policy actually is. Loud shouts through public megaphones … run the risk of triggering adverse shifts in aggregate supply.

“Keynesian” policies (like those advocated by Krugman) are most successful when they are enthusiastically adopted by were not generally anticipated, much less effective when they are both adopted but also anticipated, and positively destructive when they are anticipated but not actually adopted and implemented.

Delong’s worry about Krugman’s policy prescriptions is that expectation of inflationary policy will induce higher wages and thus depress supply. He’s guessing that in the case of Japan this effect would have been smaller than than the increase in demand. On net, his guess is that output would have risen under a Krugman policy regime.

So, assuming we take as given Krugman’s contentions that our present circumstances are very similar to Japan’s experiences in the early 90s, the salient questions are: how similar are Krugman’s policy prescriptions today to what he was advocating, and Delong was criticizing, for Japan? How salient are Delong’s criticisms? Did Japan follow Krugman’s advice and how did that work out for them?

UPDATE: I don’t see a discussion of wages or employment in Krugman’s book. He seems to be claiming in his post that deflation (along with sticky nominal wages), increased union power and minimum wage laws don’t increase real wages or at least they didn’t during the Depression. Why is he going on about nominal wages? Nominal wage supports don’t have cause unemployment, but they do when combined with deflationary monetary policy.

I’m missing something.

The Keynes chapter Krugman cites has a basic general equilibrium argument against the standard supply/demand story:

For the demand schedules for particular industries can only be constructed on some fixed assumption as to the nature of the demand and supply schedules of other industries and as to the amount of the aggregate effective demand. It is invalid, therefore, to transfer the argument to industry as a whole unless we also transfer our assumption that the aggregate effective demand is fixed. Yet this assumption reduces the argument to an ignoratio elenchi. For, whilst no one would wish to deny the proposition that a reduction in money-wages accompanied by the same aggregate effective demand as before will be associated with an increase in employment, the precise question at issue is whether the reduction in money-wages will or will not be accompanied by the same aggregate effective demand

Keynes spends the rest of the chapter arguing adjusting real wages (or keeping them stable) is easier/better/preferable for unstated reasons via monetary policy rather than “fixed money wage” policy… whatever the hell that would be.

In other words, I haven’t a clue as to why Krugman thought this chapter was relevant.

Did I mention I’m missing something?

BTW, Krugman’s book wasn’t nothing special. Its a decent rehash of recent mania/panic/crash history; it could have been a chapter or two in an updated version of Kindleberger’s book. I did learn Krugman thinks fiscal stimulus is a good idea right now. He doesn’t say why. I also learned he thinks the real problem with the financial crisis is in the shadow banking sector (banks without the columns and marble) and he thinks increased credit in the traditional banking sector is a sign businesses are leaving shadow banking. Somehow this means we need to bail out the shadow banks.

If you ask me, increased demand for traditional banking is a sign that the financial turmoil will have limited impact on the real economy, i.e. epsilon is small to use notsneaky’s notation. Yes, there is a 1930’s style bank run going down in the shadow banking sector, but unlike the 30’s we have a whole legit banking sector (not to mention the Fed’s direct participation in the commercial paper market) as backup.

Epsilon is really small

Essential reading from NotSneaky.

My sense is that epsilon (the effect contraction in the financial sector will have on the non-financial sector) is small in the short run and zero in the long run. There are some transaction costs in finding a new bank for “real” economy businesses if their old ones stop providing credit, but in the end we’re talking about a couple strokes on a keyboard and maybe a walk further down the block.

Is there any “micro evidence” that can help us pin down this parameter?

Also, the large dip in financial paper with no corresponding dip in the non-financial sector on the first chart here is evidence of a small epsilon.

As long as there’s at least one bank standing at the end of all this, I don’t think epsilon can get that big. So maybe the bailout is attempting to throw money at this problem hoping to avoid this non-linearity.

In the long run, epsilon is zero as everyone in the non-financial sector has found alternative sources of credit. The fact that a bunch of smart ex-bankers will become smart middle managers in the real sector is gravy. But because someone was stupid-efficient at moving electronic bits shaped as dollars around doesn’t mean they’ll be good at moving electronic bits shaped as goods and services and it probably means they’re just plain bad at moving atoms around (although, Bankers tend to work out a lot).

Using NotSneaky’s handy chart, I predict a recession of about 2% peak to trough.

UPDATE: We’re on our way. GDP down 0.3% last quarter.

Tyler Cowen gets Fisked

What is a credit crunch? At first, I thought when people were using this term they meant credit markets weren’t in equilibrium. There was no market for credit. Then when people started talking about the increasing TED spread — basically the price of very short term loans — I thought they meant a credit crunch was a contraction of credit supply. You know banks were all of a sudden more risk averse and they weren’t extending credit that should be extended.

But then someone said, “hey, volumes of credit are actually increasing!” Basically, if supply is decreasing, we’d expect increasing prices, e.g. an increase in the TED spread, but also decreases in quantities, e.g. lower volumes. If volumes are up and prices are up, this is consistent with increasing demand.

To which Tyler Cowen replies with this weirdness. Basically, he’s saying a credit crunch is an impending decrease in supply (or demand even) for credit. Why is this weird? A commenter on that post explains:

“As for the current financial crisis, my view of the data is that many borrowers have been drawing on their pre-existing lines of credit like crazy, for fear that their chances to borrow may be drying up. “

So, your view of the data is that an increase in the amount of loans and credit available is a sign of a freezing of credit and an unwillingness for banks to lend. This is a very convenient position to take. A reduction of loans and credit is a sign of a credit crunch and an increase in loans and credit is also a sign of a credit crunch. This is like the game of flipping a coin where if you flip heads you win and if you flip tails I lose.

“Even now it remains unclear whether these options will be replenished and of course if they are not that means trouble.”

I see…so, we are not in trouble yet, but because in the future we might possibly have a reduction in loans and credit, that definitely means we are in a credit crunch now.

“It does not necessarily show up in current period credit flow data and in fact it may show up counterintuitively as a spike in borrowing.”

A spike in borrowing also means a spike in lending from the banks. But a credit crunch is where banks are unwilling to lend. Now, with new Orwellian double speak, a credit crunch is when banks are willing to lend to everyone and his brother. Some credit crunch.

“I am puzzled by Alex’a admission that there is a recession; no matter which way you assign the causality, doesn’t that mean credit should be contracting?”

Causality does matter. If borrowers choose not to borrow this is not a credit crunch. A reduction in demand for loans due to a recession would not be considered a credit crunch. The credit crunch would have to originate on the supply side. Banks would have to be unwilling to lend to borrowers for there to be a credit crunch. A reduction in loans and credit is a necessary but not sufficient condition for there to be a credit crunch.

Investments are the most volitile component of national income. When GDP is high, investment goes really high and when GDP is low, investment is really low. We’d expect, if we’re entering a recession, to see investment and thus the demand for credit go down. Its hard to call this normal contraction of demand for credit a credit crunch.

The data aren’t telling us we’re in a credit crunch, given a half-way meaningful definition of the phrase “credit crunch”. In fact, the data are consistent with increases in demand for credit and so increases in investment.