## Dangling epsilons

Whenever I look at an estimation equation like this:

from this paper, I wonder what’s in that dangling epsilon term. In this equation we have Y’s on the left hand side. And I think to myself, “what kinds of things produce Y’s (or changes in Y’s)”. Now, Y is GDP and from my intro macro class I remember things like K’s and L’s produce Y’s. So given there’s no L’s and K’s in the equation, they must be in the dangling epsilon.

Changes in labor and capital are in the error term, but this is only a problem if changes in these factors of production are correlated with the other variables on the right hand side that aren’t in the error term.

Ah-oh.

It seems to me changes in labor and capital are correlated with changes in government expenditures (and military expenditures in particular… after all, the military is the worlds biggest employer). So while this paper claims to show the effect of military expenditures on output, it really shows that military expenditures create jobs and attract capital (they have an IV but as far as I can tell it doesn’t address this issue).

But can we salvage the overall message of the paper? Isn’t creating jobs and attracting capital exactly what we’re trying to do with fiscal stimulus? Yes, but not if it means that labor and capital is coming from other States. GDP is increasing in the States that have more military expenditures but is necessarily decreasing in the States that are losing workers and capital. Because these two effects cancel each other out, the “true” fiscal multiplier is less than the 1.5 estimated by this paper.

Mike suggested for those interested in the foreclosure issue this paper.

That paper says this paper estimates the deadweight costs of foreclosures.

No it doesn’t ((This is one of those cases where something is so blindingly obvious that I think to myself that I must be missing something at a fundamental level. If this is the case, please school me.)). It measures (or attempts to measure) the price discount of foreclosed homes. It turns out for observably equivalent houses, foreclosed houses sell for 20-25% cheaper.

This means one of two things:

1. There’s some unobserved thing about foreclosed homes that make them worth less
2. Banks (or owners of the foreclosed property) sell them at a discount

Neither of these things is an inefficiency. In the first case, the price just reflects fundamentals. In the second case, the banks loss is exactly balanced by the buyers gain.

Now, what is inefficient about letting underwater houses foreclose?

## Question for those that want to stick it to the banks

Some seem to really dig plans for the housing market that stick to the banks. I’m down; I dig redistributional policy and we should encourage people to do what’s best for them and their families (even if its bad for the banks for “the system”).

I just took a peak at the CalPERS annual statement and it appears they have a huge stake in the bank-side of the mortgage industry (over \$10B in MBS and large positions in bank stocks). So here’s the question: what theory of justice requires redistribution from public service retirees to underwater home owners? Less snarkily: why are you so sure that the owners of these banks are any better off at the moment than the folks that bought too expensive houses?

Wouldn’t it be better to directly help poor people?

## Increase inflation AND combat structural issues

Inflation is below target. Increasing output and decreasing or stagnant inflation is an indication that inflation expectations are becoming unanchored. That’s bad. Inflation should not spend too long, too far from its implicit target of 2%.

Structural unemployment is high right now. Instead of just dumbly extending UI benefits and scratching our heads on why unemployment among the young is increasing after three subsequent increases in the real minimum wage, we should do something about it.

Politically — I’m only guessing because I’m no expert — dealing with structural unemployment would be cheaper. The Fed, more than anyone else, knows how to increase inflation and they have figured out the cheapest way to do it. You might think, however, there are personnel issues at the Fed, i.e. too many hawks, that make “doing the right thing” impossible. And so, you might think, political pressure would have an effect on policy in the short run. I’m not sure why you think that. The FOMC meets only ever so often and they never take radically new action one way or the other. Policy stickiness is one of the most reliable facts about Fed policy. According to Goodfriend and King, even Volcker’s radical disinflation started over a year after he became chairman (and it took another 1/2 year to start to see employment effects). BTW, we’re not changing the chairman for a long while and even supposing Bernanke was suddenly reborn a Sumnerian, how do you think employers would react if the Fed announced bold action one way or the other? Ditto for massive institutional changes at the Fed.

In any case, with the Bernanke Put getting close to its strike price, the monetary policy car is going in the right direction. Given the current institutional framework, political pressure is not going to speed the car up.

But we can do more about structural unemployment. All it would take is for some enterprising think-tank researcher to buddy up with a promising young politician ((I’m thinking there may be an “only Nixon can go to China” effect here, but I’m sure a charming Democrat could pull it off too)) and to come up with a bold plan to deal with it. Radical changes to the UI system. Radical policies to deal with labor immobility. Radical interventions in the housing market. If engineered and sold to help reduce unemployment and as a package deal, these policies would be supported by both sides.

PS – We shouldn’t look to Europe for examples for good labor market institutions… the EU’s unemployment rate is higher than the US’s right now.

## Did you know?

After Kockerlakota dared suggest there are substantial structural problems in the labor market (right wing scum!), the very next paragraph was:

Given the structural problems in the labor market, I do not expect unemployment to decline rapidly. My own prediction is that unemployment will remain above 8 percent into 2012. Persistently high unemployment of this kind will impose considerable losses on many of our citizens. Good public policy requires that we help mitigate their losses via a well-designed unemployment insurance program. Recent economic research, including some done at the Federal Reserve Bank of Minneapolis, shows that such a program will not feature the termination of benefits after 26, 52, or 99 weeks. Instead, a good insurance program should offer constant benefits over the entire duration of an unemployment spell, however long. It should provide incentives only through the level of those benefits, not through their timing.

and then he cites Shimer/Werning (2008). That paper shows just what Kockerlakota suggests above, i.e. if the unemployed have good access to liquidity (i.e. a part-time job, bridge loans or savings) there should be no cut-off of unemployment benefits (left-wing nut job!).

## Question

All the heat on the issue of AD policy overshadowed and even delegitimized discussion of policy to deal with structural issues in the labor market. Suppose the latter policies were cheaper economically and politically. In this case, while the benefits are smaller (only 1/3rd of unemployment would be addressed according to RA) the cost/benefit analysis would still come out in favor of policies addressing the structural issues.

Was the acrimony and name-calling worth it?

## Setting expectations

Evans and Honkapohja’s work on learning in macro is important. Watch this to get a sense for what they’re doing:

But learning dynamics are not well understood empirically. Prof. Evans describes the dynamics under adaptive learning. Under rational expectations the economy would just pop to the good equilibrium. Under other learnings schemes the dynamics would be different. How do we know which dynamics describe the actual economy? We’d need to have empirical tests of the different learning regimes. We don’t have these tests.

In the same vein, Prof. Evans is just speculating about where the economy is right now in the phase diagram. He suggest we’re close to to the deflationary zone where things go to hell if the Fed raises interest rates. In fact, there’s no a priori way to know where we’re at in the diagram — we don’t have good measures of expectations.

(ht Thoma. BTW, Thoma says that Evan’s model shows increasing interest rates “increases rather than decreases the chance of a deflationary spiral”. They do no such thing. The little arrows on the phase diagram aren’t invariant to policy, see the paper figure 1. Suppose you’re close to the deflationary zone. Where you were before the policy may be in the deflationary zone after the policy, but your location after the policy is determined, in part, by the policy and it doesn’t have to be in the deflationary zone. Anyway, this probability could be computed as simulated comparative static, but Evan’s didn’t do this in his paper.)

## Quit picking on Japan!

Here’s the per capita GDP for the G8 countries (relative to the USA):

You can take two lessons from this chart.
1) Japan hasn’t had bad monetary policy relative to, say, the continental European countries
or
2) Monetary policy just doesn’t matter in the long-run

Also, the more you stare at these real GDP per capita charts, the more you think the 1980s in Japan was an outlier (aka bubble).

## What is structural unemployment?

There seems to be a disconnect between how economists (and Fed economists in particular) use this term and how bloggers (and left bloggers in particular) use it.

Some definitions:
“The unemployment resulting from wage rigidity and job rationing is sometimes called structural unemployment.” — Mankiw’s intermediate text

“Frictional unemployment [w.a. where the only other kind of unemployment they mention is cyclical unemployment] is the unemployment that exists when the economy is at full employment.” — Dornbusch, Fischer and Startz

“The part of unemployment associated with the institutional features of an economy, including hiring and firing costs and the structure of the unemployment compensation system.” — Jones’ intermediate text

There may be confusion about this term because there seems to be such a multitude of definitions (wikipedia’s definition talks about skill mismatch). I like Jones’ definition the best, but the point I want to make is that the lefty bloggers are reading more into these definitions than necessary.

There’s no reason to think the relationships between “wage rigidity”, “full employment”, “institutions” or “skill mismatch” and unemployment are constant over the business cycle. You can make good arguments that the mechanisms producing these relationships are responsive to overall conditions in the economy (I won’t). And… and!… estimates of structural unemployment suggest that it is time-varying: higher during recessions and lower during booms (anyone have a good cite for an estimate of time-varying NAIRU?).

When the Fed folks say structural unemployment is high right now (e.g. Altig or Kocherlakota), they’re not saying its permanently high. They’re not trying to pull an inception making us feel like permanent high unemployment is ok. They’re observing momentarily high structural unemployment that fits in a pattern consistent with historic experience.