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.

They’re both speaking English, I think

How is it possible that this person (and his commenters) and this person live on the same planet?

A definition of economics is “the study of incentives”; an idea that’s pretty well baked into my brain at this point. This means I have a big problem: I have trouble even empathizing with people who don’t think incentives matter. The word “idiot” comes too quickly to my mind.

(BTW, read the second link. He finds it plausible that increasing taxes on rich workers is regressive policy, at least in a small open economy.)

Rhetoric matters

I recognized myself in Krugman’s remarks about otherwise bright, educated people who need to have arguments about international trade explained to them in baby talk. I’d hate to be on the side of the creationists in any argument, so I started asking questions.

Sierra Madre

Referenced Krugman essay, the Landsberg post that referenced it and his post that provoked Sierra.

Let’s talk about… financial education

This post and then this post passed by in succession in my rss reader this afternoon. Since its hard work to make real connections between things, I’ll let this random pairing do the work for me.

First reaction to Mike’s post on financial education: education is paternalism. To wit, Mankiw’s views of economics education are exactly like a Marxist’s need to raise his students’ consciousnesses. We have views we think our students should have. There are “good” views and there are “bad” views. I think we’re going to have to live with this sort of paternalism.

Second, financial education, and personal finance in particular, IS NOT economic education. Personal finance is about individuals making decisions about particular goods and services. Economics is about how many people’s decisions aggregate up into market behavior. Like waaay different.

Third — and here’s the lazy connection with the Robin Hanson post — financial education is just an instance of rationality education. If students could learn to be more rational (and they use that reason), they would be better consumers of finance when they get out in the world. Because some students aren’t smart enough and most aren’t so inclined, they can’t be taught to be more rational in general. So, financial education needs be a set of rules of thumb with a sprinkling of general principles.

Example: everything you need to know about interest rate calculations is taught to you in 6th grade math class. Because students are too dumb or disinclined to care, they don’t make the connection. So we need to teach them specifically how to calculate the interest payments on credit cards and point out to them how many big screen tv’s they won’t get to buy if they rack up their credit card balances.

The guiding principle would be to teach rules of thumb that, if followed, would lead to people making the least bad mistakes, e.g. its better to scare the bejeezus out of students about credit cards even if it leads them to forgo getting them. That said, people learn from mistakes so we shouldn’t aim to prevent all mistake making.

Aside: I consider myself a pretty staunch anti-paternalist… the big fight with the Real Scientist right now is over whether we should cut checks to poor people or buy health care for them. She says, and I’m paraphrasing only a little, “they’re too dumb to buy health insurance themselves so we have to do it for them.” I say that I’d hate to be treated that way, like a child, and so we should just give income subsidies to the poor and let them figure out what goods and services they need to buy.

Anyway, I’m an anti-paternalist EXCEPT when it comes to education and specifically when it comes to teaching people how to think. To me, it better for people to learn to think for themselves than for others to think for them. A second best: people should at least act like they’re thinking for themselves (i.e. following rules of thumb). At least in this case, there’s at least a chance that people will learn to think for themselves and become more rational.

In all three cases, though, paternalism is involved.

It is profound and earth shaking…

… every time I run into a statement like this: “But all interesting models involve unrealistic simplifications, which is why they must be tested against data.”

We can know things a priori, but we can’t know how important those things are a priori. A model can tell us how a particular mechanism operates, but it can’t tell us how important that mechanism is. Effect size can only be determined by looking at the data.

I’m sure there’s something wrong with my brain that can’t internalize this fact. I just read Landsburg’s Big Questions and this was his major theme. (BTW, I liked the book and here’s a review at /.)


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.

Walk out?

I don’t think I’ll be participating in the planned walk out Thursday at UC campuses. I’m not clear what the goals of the walk out are to be. Are they to protest a short-term budget shortfall? To dispute the priorities in budget balancing? To lament the lack of voice in the process?

I’m not sure how walking off the job on Thursday will change the short-run budget issues. Short of printing their own money, neither the State nor the University can do much about the deficit. Of course, they could have done things in the past to have mitigated some of these problems (e.g. the University could be less dependent on State funds and the State could have institutions that make it less of a fiscal mess). But a protest today can’t change past actions. The best that can be said on this front for the walk out is that it could provide a modest encouragement towards making structural changes in the way the State and University do business; a very modest encouragement.

Also, the president doesn’t act as dictator nor the Regents an oligarchy. Shared governance means the University is also run by the faculty and they’ve weighed in on the issue. According to them, faculty and research quality should have precedence over access and affordability. “Our view about affordability is simple: if the state of California once again adopts the view that access and affordability are public goods worth supporting, they will be readily achievable.” To them, getting poor folks into the University is a public good and thus, it should be provided by the public, not from cuts in their paychecks.

Now voice: maybe there’s a point in protesting because we didn’t have a say in the process. But we do have a say. Students, mostly new students, can vote with their feet. There are plenty of private universities in the State and plenty of competition of all stripes outside the State. If fellow grad students don’t like the product they’re buying, then they should stop buying it.

Krugman was looking under a lamppost

One more on macro from Kocherlakota. Everything on his list seems right to me. As I’ve pointed out before, he notes that macro folks (at least those that got their PhD since 1990) have studied heterogeneity, frictions, bounded rationality and government intervention and they’ve done so at the core of their research agendas. He points out that the salt/fresh water divide doesn’t exist these days. He admits, though, there’s been little study of financial frictions, but its worth pointing out that few macro models assume complete financial markets.

Two of his observations are very close to what I was saying a while ago. In a post called “the extent of our knowledge“, I talked about how macro models hide what we don’t know in so-called exogenous shocks. If you want to know what a macro model isn’t telling you, you look at the shocks and Cogley and Nason taught me that lots of stuff can be hiding in those shocks. Kocherlakota says,

The sources of disturbances in macroeconomic models are (to my taste) patently unrealistic. Perhaps most famously, most models in macroeconomics rely on some form of large quarterly movements in the technological frontier. Some have collective shocks to the marginal utility of leisure. Other models have large quarterly shocks to the depreciation rate in the capital stock (in order to generate high asset price volatilities). None of these disturbances seem compelling, to put it mildly. Macroeconomists use them only as convenient short-cuts to generate the requisite levels of volatility in endogenous variables.

Second, he points out that macroeconomists are a technical sort of people and they don’t talk much. This is bad for me because, while I like to geek out, I’m more of a talker. Its also bad for the profession because it means we do a bad job at communicating our ideas to lay people and to other economists. Early in the crisis, when everyone went all Keynesian, I was lamenting that the best ideas in modern macro aren’t in the text books.

One of his throw away lines: “some departments have shockingly few young tenured scholars in this important field (including large departments like Harvard and Princeton [and Berkeley]).” And this may explain why Krugman (and Delong) have a hard time appreciating the current state of macroeconomics. They don’t know any modern macroeconomists.