Sam, Fred and the deer in the road

A story:

Fred is driving a car down a deserted highway in the middle of the night. His friend Sam is in the passenger seat. Fred reaches down to pick up something he dropped, taking his eyes off the road ((or maybe he doesn’t know he’s driving)). When he lifts his gaze back to the road, a deer has appeared.

What should Fred do? What should Sam do?

Clearly Fred should make a measured jerk of the wheel and swerve out of the way of the deer and Sam should do nothing. If Fred doesn’t swerve out of the way, he is responsible for the resulting crash. If Sam yanks on the wheel causing the car to go out of control and slam into a guard rail, he’s responsible for making the crash much worse.

The deer in the road is ultimately the cause for the crash, but as a force of nature he can’t be blamed for it. It is the actions or inactions of the people in the car that determine culpability. Because their actions determine whether or not the crash occurs and its severity, their culpability may not limited to not preventing the crash but for making it worse.

Friedman and Swartz found that Fred was at fault for the crash because he didn’t swerve when he should have. Ohanian has conjectured and has found some support in the data for the idea that Sam is at fault for making the crash worse because he jerked on the wheel.

But in the historical example, didn’t Sam jerk the wheel again after the car hit the guard rail? Yes, but jerks on wheels can, by luck, right out-of-control cars. Luckily for Sam, Eggertsson has found this was the case in the historical example. In that case, a jerk on wheel in the right direction happened to be productive.

Notice this doesn’t mean wildly jerking the wheel and sending cars out of control is a good idea. Also, the lucky productivity of the second jerk on the wheel doesn’t mean the first wasn’t bad.

The blogosphere is catching up

I see the blogosphere has caught up to the early nineties in the macroeconomics debate. As Larry Summers argued — in 1988! — there are problems, like the Great Depression, with real business cycle theory. How can supply shocks explain such hugemongous declines in GDP?

Cole and Ohanian subsequently took up that challenge — in 1999! — finding that while real shocks explain about half of the contraction, recovery from the Great Depression was much slower than predicted by RBC. They claimed this was because New Deal policies were contractionary. This lead to responses from folks like Eggertsson.

The neo-classical view of the Great Depression is captured in a new book edited by Kehoe and Prescott. There are no macroeconomists, except perhaps Prescott, who believe real shocks are the only important shocks to the economy. Its important to point out, though, that no matter how kooky Prescott is, real shocks explain well over half of fluctuations.

The Economist doesn’t understand marginal analysis

Strange for a magazine with such a name that they don’t know about Alfred Marshall and his marginalist revolution. See, when someone uses marginal analysis to show, unequivocally, that increases (*ahem* marginal increases *ahem*) in unemployment insurance benefits depresses employment, its not ok call them names for not doing inframarginal analysis. Its not ok to call them names for not doing inframarginal analysis because inframarginal analysis in our current policy environment is wildly inappropriate.

The first $1838 of UI (and food stamps and TANF) keeps families from starving and gives them shelter for a month or so ((This amount keeps a family of four above the poverty threshold. UI benefits in California are up to $450 a week per wage earner. If the family is low income, then the family probably qualifies for other welfare programs and then the issue is redistribution not efficiency.)) while the bread winners look for new jobs and it prevents them from having to sell off their assets, which, as The Economist mentions, would exasperate the demand shock. Every dollar above that encourages them to search longer and thus increases unemployment.

Casey Mulligan is talking about marginal increases in UI not eliminating them!

UI-apologetics come from a confusion between redistributional policy and efficient policy. You don’t need to make tenuous arguments for efficiency (“without UI people would sell their assets off and cause further decreases in AD!!!”), just argue directly for redistribution. Here, I’ll help you: the recession has made me realize that the poverty guidelines are too low. Too many people are too near the jaws of poverty for my comfort. The guidelines should be increased and more people should qualify for welfare programs.

History of all of modern macro (ignoring the last 30 years)

Prof. Delong has a nice summary of the pre-RBC (aka “purist”) macro literature of the 70’s:

The underlying argument went something like this: (i) There is no sense talking about anything like “involuntary unemployment”: markets clear, and at all times people work as much as they want to work and firms produce as much as they want to produce. (ii) Workers work more relative to trend when they think their real wages are high, and firms produce more relative to trend when they think real prices for their products are high. (iii) Workers work less relative to trend when they think their real wages are low, and firms produce less relative to trend when they think real prices for their products are low. (iv) Workers and firms have rational expectations, so if they expect government fiscal or monetary policies to expand (or contract) nominal demand they will expect nominal wages or prices to rise (or fall) accordingly. (v) Thus if a predicted government-driven expansion (or contraction) raises (or lowers) nominal demand and thus their nominal wages or prices, they will understand that their real wages or prices have remained unchanged–and hence will not work more or less, and will not produce more or less. (vi) Only if nominal wages or prices rise (or fall) in an unexpected fashion will workers or firms get confused, and work and produce more (or less) than the trend. (vii) But with rational expectations the only cases in which government policy produces unexpected rises or falls in wages and prices is if the government policy is random. (viii) In which case its effects are random. (ix) And so government policies–not just fiscal but monetary policies too–cannot be stabilizing but only destabilizing. (x) Hence the best of all policies sets a predictable and constant rule for monetary and fiscal policy and does not deviate from it no matter what.

Regarding (i), (ii) and (ii), there’s a growing literature in macro on unemployment. Robert Hall has done a lot of work on this (e.g. note that he uses some psychologist-pleasing behavioral assumptions in wage bargaining). This macro research has done a very healthy thing; it inspired research questions for micro folks (e.g.). The back and forth between macro and micro people on this issue (and the state-based vs. time-based pricing stuff) suggests, at least to me, that macro is far from insular. In fact, I’d say the field is learning real things about the real world. We’re learning practical things that pragmatist might find interesting if they paid attention.

Also, these employment search models — ones where employment doesn’t hinge solely on the labor/leasure trade-off (i.e. doesn’t require unemployment to be equivalent to vacation time) — have recently found themselves studied in the DSGE framework (e.g.) where they’ll quickly find applications in policy making.

All modern macro papers have sticky prices and wages. Recently maligned Nobel prize laureate Robert Lucas has found evidence consistent with sticky prices. In other words, (iv) and (v) may have been the purist view in the 70’s but they don’t reflect the current state of macro.

As to the consequent points (vii to x), modern macro doesn’t deny discretionary policy can have short-term effects, but once the public learns policy makers are using their discretion, they will expect it, policy becomes incredible and it becomes inefficient or ineffective. Policy makers will say one thing but the public will suspect they’re lying. Policy makers will promise to be good and do what’s right in the long run, but the public will suspect they’ll do what’s most expedient. There’s a good discussion of this in the introduction of Micheal Woodford’s textbook.

And have you ever noticed how deficits aren’t counter-cyclical ((Changes in the deficit and GDP growth have had opposite signs only 27% of the time since Eisenhower, if I have my sums right.))? Fiscal policy looks awfully discretionary.

You might interpret the actions of the Fed last year as discretionary, but that entirely depends on what rule (or which rule-making framework) the public thinks the Fed was using. If the public thought the Fed was targeting inflation, then the Fed’s actions may not have looked discretionary at all. If it thought the Fed was doing something because something had to be done, then, yeah, the Fed’s actions looked discretionary. It may be too that last Fall was so unprecidented any action on the part of the Fed would look like it was acting with discretion. On the other hand, if the Fed was seen as acting in its prescribed role as lender of last resort and so it wasn’t acting expediently, its policy credibility may sill be intact. Its hard to tell, but a spontaneous dirty fight between economists — and their political slaves ((Yes, my tongue is firmly planted in cheek)) — about the relative merits of fiscal and monetary policy during that time didn’t do much for the credibility of policy making.

In any case, Professor Delong says, “So when the financial crisis began in the summer of 2007, we Pragmatists largely ignored the Purists, for they seemed to have nothing to say.” There’s been a lot of progress in macro since the Puritan 70’s. The professor has seemed eager to attack finance people and he debated a theorist here in Davis, but as is evidenced by this post he has had limited engagement with modern policy oriented macroeconomics.

And this is all an attempt to change the subject. For standard counter-cyclical policy when given a choice between effective monetary policy and effective fiscal policy, monetary policy wins hands down (and I’ll go out on a limb and say Prof. Delong’s hand would be down too). Monetary policy is faster and, when you consider policy expectations, more efficient. The current debate is over whether or not monetary policy can be effective right now. Are we in a liquidity trap? Is the Fed pushing on strings? Theory says no; monetary policy can be effective when short-term nominal interest rates are zero. What does the evidence say? Well, there hasn’t been very many instances where those interest rates were zero, but monetary forces got us out of the Depression. And so far we’ve managed to stay out of deflationary spiral, so chalk one up for monetary policy at the zero lower bound.

Economics History course at CR

For the two of you in Humboldt reading this blog (three if you count my mom… howdy Ma!), I’ll be teaching an economic history course (econ 20) at College of the Redwoods this summer starting next Tuesday. Lectures are in the evening, so you can use work as an excuse. Sign up!

Yes, we’ll be covering the Great Depression and “historical lessons applied to the current recession”. Other than that, I’m taking requests for topics.

Learn economics, be entertained

I think economics turns students off because of its Libertarian bent… all the invisible hand stuff ((All of which I buy hook, line and sinker.)) makes ’em think economics=”greed is good”. This, on the other hand, is how economics should be taught:

In fact, if Joseph Heath’s Filthy Lucre turns out to be any good, I’ll use it as an intro economics text.

Psychology : Economics :: Physics : Chemistry

“Markets don’t seek efficiency because investors aren’t rational.” Yeah, well, gas molecules aren’t rational either, but they obey very simple regularities in large numbers. Rational-expectations theory doesn’t actually require individual investors to be rational, it merely predicts that en masse they will behave as if they are.

esr

I’ve made this analogy before and I think its good. Psychologists and economists, like physicists and chemists, study things that exist at much different levels of abstraction. An important implication of this is that behavior at the lower level doesn’t easily translate into behavior at the higher level. For example, the fact that individual molecules move in patterns that are called Brownian motion has little baring on the fact that when you put a few billion molecules of oxygen and a few billion molecules of hydrogen together you get a few billion molecules of water. Brownian motion is way neat, but if in some other universe it turned out that molecules just sat there laying still, it’s possible to imagine that it wouldn’t change the chemistry.

In fact, the chemistry was discovered before Brownian motion. In other words, we knew about the higher level behavior before we knew about the underlying mechanisms and this didn’t hamper our ability to do analysis at the higher level.

If this analogy works, then all this talk about animal spirits and psychology’s supposed obvious implications for economics is mis-guided. Its perfectly possible for individual humans to be irrational, idiotic twits and for the economic system that emerges from their individual actions to appear as though it is rational. If fact, the experiments of Vernon Smith show that this possibility is actually probable. In many experiments ((Here’s a counter-example; a paper on asset bubbles that shows price theory doesn’t seem to hold… asset price bubbles are common in the lab. Smith says his experiments show that the problem with theory is that it assumes common knowledge of rationality. It assumes people believe other people will do what’s in their best interest. Asset bubbles don’t arise in the lab after the same set of subjects repeat the experiment a few times and thus know that the others are rational.)), Smith shows the behavior of idiots, when aggregated, quickly converges to market outcomes that look like those outcomes predicted by neoclassical theory. In other words, behavior at the lower level of abstraction doesn’t necessarily impact behavior at the higher level of abstraction.

Here’s why, however, this might not be such a great analogy. In the case of physics and chemistry, the higher level abstraction, chemistry, is much more intuitive than the lower level abstraction, physics. We see chemistry every day; its very easy to create chemical reactions in your kitchen. The behavior and structure of atoms, on the other hand, is really strange and inaccessible. The solar system analogy helps, but atoms are still very strange places to think about. In the case of psychology and economics, on the other hand, the lower level abstraction is more accessible and the higher level abstraction is, well, more abstract. We all experience individual psychology and irrationality. Its so obvious. Economics — as I can attest to now having taught it for four years — is less obvious.

Mankiw’s introduction to DSGE

I genuinely want to know if this does anything for anyone. Does understanding the basics of DSGE help you understand the economy better (vs. the traditional AD/AS model or vs. whatever theory you have floating in your head)? Does it help you understand the current recession better?

Seriously, what do you think? I’m teaching intermediate macro out of Mankiw’s book this summer and I’m wondering if this chapter is worth it or not.