Buiter, good macro critic?

Google scholar and a minimal knowledge of the DSGE literature allows one to refute Buiter’s claims in less than 10 minutes. Someone should really give him a quick lesson on Google scholar.

No complete markets? Nope (first page of “dsge incomplete markets“).

No asset bubbles? Negative. (third result from this search: “dsge asset bubbles“)

Only linearization? Not really. (first result of this search “dsge nonlinear solution techniques“)

Can we have better macro critics please? Like this one or this one, I mean.

BCA all the way

The more I think about it, the more I think business cycle accounting should be the back-bone of the macro curriculum. Teach the growth models and then use BCA to show how the economy strays from that ideal. Wedges are so much more intuitive than fundamental shocks.

You still have to learn real business cycle models, adding money, the mechanics of sticky prices, credit channel stuff and all that, but I think BCA is a nice way to frame the problem of business cycles.

Couldn’t this even be taught to undergrads? Instead of the theoretical suspect (and outdated) Keynesian model, BCA would introduce business cycles as an empirical problem. Something we have a great deal of data on but not a great deal of understanding. Also, because the BCA stuff points to labor frictions as a major contributor to business cycles ((Certainly not a robust finding because this literature is young.)), they can be a nice segue to unemployment.

Teaching business cycles this way to undergrads — without introducing a causal model — would make business cycle policy discussions hard. Maybe this is ok. Teach policy in the Public class. After all, they don’t teach medicine in physiology class.

Homework assignment: modern macro book outine

Dear eminent-macro-economist-who-would-have-a-chance-in-hell-to-get-this-to-stick –

Please write this book.

  1. Intro
  2. Intertemporal consumption choice
  3. Growth
  4. Growth policy
  5. Labor or leasure choice
  6. Worker flows and unemployment
  7. Expectations (including learning stuff)
  8. Business cycles
  9. Monetary policy
  10. Political economy and fiscal policy


The failure of modern macro

Thomas Sargent complains that the arguments for the fiscal stimulus “ignore what we have learned in the last 60 years of macroeconomic research.” This is his fault. He and the other big names of modern macro have failed to produce a simple model (or a series of simple models) to replace the Keynesian one in undergrad textbooks.

Policy makers, and even economist that don’t specialize in macro, were taught to think about the economy like Keynes did 75 years ago. They shouldn’t be expected to absorb cutting edge research only taught in grad schools. The problem is that this stuff is no longer cutting edge. The rational expectations revolution is nearly 35 years old.

In macro, there remains a gearhead culture. To understand 30 year old models you need to learn overly complex jargon and graduate level mathematics. There still isn’t a standard tool box for solving models… you’re expected to program everything from scratch. Serious macro job candidates are expected to know how to prove fixed point theorems and its not enough in your job market paper to have an interesting economic problem (if that’s even necessary at all), but you have to extend some already complex model. Those extensions have to be “tractable” but not necessarily “understandable” (its not clear to me the point of the former without the latter). This means wildly unrealistic assumptions that happen to make the math work, even if they contradict each other in spirit, are ok.

I actually don’t mind all that stuff. That’s why I signed up to do it. Someone, though, needs to take stock of the economics — rather than neat mathematical theorems or cool econometric techniques — modern macro has taught us and write it down in an undergrad textbook.

The trade-off between private diversification and efficiency

After making pretty easy work of Krugman, Waldman argues, “there’s a trade-off between microlevel diversification and macro-efficiency.” He then concludes:

If we want to maintain a well-diversified aggregate portfolio, it may be necessary to restrict the degree to which the portfolio of firms and individuals can be diversified. This implies forcing individuals to bear more risk than they would otherwise choose, in order to reduce systemic risk. We might be better off by letting individuals shed risk via some form of social insurance while forcing investment choices to be sharp, than by encouraging people to blur the information they present in their portfolio choices in order to diversify and hedge.

I’m reading Xiaokai Yang’s textbook on inframarginal analysis. The preface is great and would be worth the trek down to the library. One of the distinctions he makes between management science and economics is business folks care about individual trade-offs and optimal individual choice while economists care about aggregate trade-offs. I agree, of course, but in my experience we spend too much on the former in the economics classroom.

Of mice and maximin

Gabriel summarizes the debate on fiscal stimulus and comes down on John Taylor‘s side (good choice). Those checks we got in the mail from the Feds didn’t increase aggregate demand; while take home pay went up, consumption didn’t. People, on average, put that money in savings (e.g. paid down their credit card debt).

This conforms to standard economic theory, but not, by the way, our cherished models ((Won’t anyone defend Keynesian fiscal stimulus?)). People that win a lottery will tend to put most of their winnings in savings and only consume a small bit at a time because they know its a one time windfall. On the other hand, people who get a raise at work will tend to consume most of the additional pay because they expect the additional pay to be in each of their future pay checks. ((Hey, what about Ricardian equivalence? In what sense aren’t all fiscal policies permanent ? Contra Taylor, “permanent” tax cuts without out spending cuts aren’t credible.))

These theoretical results depend on people having access to credit. Hypothetically, suppose you’re a poor student expecting to get a lavishly paid job when you go on the job market next year because you expect no Economic department budgets will be cut in the aftermath of the Great Depression 2.0. Let’s say. Anyway, you know you’re income will be much higher in the future and you’d like to spend some of that higher income today. There’s no reason for your future self to live high on the hog while your stuck in the present eating Top Raman. In other words, you’d like to borrow from your future self. Well, that’s not very likely because access to credit for poor students is limited.

Now, suppose the government sends you a check for $500. Even though this is a temporary increase in your income, contrary to that fancy economic theory above, you’re going to consume it all and not save any of it. You do this because you wanted to borrow money from you future self, but weren’t able to. You not saving is, in effect, you borrowing from your future self.

But darn us economist, here we are talking about efficiency again. What if government actors care about maximizing the consumption of the least well off? Sure their stated preferences, as evidenced by their reference to Keynsian stimulus in public statements, are for efficiency. But stated preferences and a smile buys you crappy happiness research. Instead the government may just care about those most hurt by recession and those most likely to be credit constrained and thus those more likely to increase their consumption after fiscal stimulus.

Does our Benovolent Dictator (with a mouse in his shirt pocket to make my title work) have maximin preferences? If his preferences reflect a typical individuals social preferences or the median voter’s typical social preferences, then my guess is yes.


A certain Wall Street Journal opinion piece set of a mini-blog storm about the roll of policy in the cause and length of the Great Depression. The piece presented five myths. Here’s my take on them:

  1. Herbert Hoover, elected president in 1928, was a doctrinaire, laissez-faire, look-the-other way Republican who clung to the idea that markets were basically self-correcting.

    UNQUALIFIED MYTH – Rauchway tells us so.

  2. The stock market crash in October 1929 precipitated the Great Depression.

    MYTH – There have been many stock market crashes that didn’t result in a depression. In fact, there appears to be no relationship between stock returns and GDP growth. But don’t take my word for it, here’s Ben Bernake:

    [T]he market crash, rather than being the cause of the Depression, as popular legend has it, was in fact largely the result of an economic slowdown and the inappropriate monetary policies that preceded it. Of course, the stock market crash only worsened the economic situation, hurting consumer and business confidence and contributing to a still deeper downturn in 1930.

    “Ah,” you say, “Ben says the crash precipitated the depression by hurting consumer confidence.” True, but that’s a bit like saying the noose precipitated the hanging.

  3. Where the market had failed, the government stepped in to protect ordinary people.

    QUALIFIED MYTH – It depends on what you mean by help. If you mean policy was efficient, then certainly much government policy was inefficient. Inefficiency comes in the form of unemployment and low GDP. Those things hurt. If, on the other hand, you mean policy prevented people from starving, you have a case. There’s a trade-off between efficient policy and policy aimed at reducing economic depravity; this is a trade-off between short-term pain and long-term gain. I haven’t seen a case that said the short term pain was so great it was worth the hit in the long-run. And for the above statement to not be a myth, you’d have to show the extreme short-term pain was caused by market failure.

  4. Greed caused the stock market to overshoot and then crash.


  5. Enlightened government pulled the nation out of the worst downturn in its history and came to the rescue of capitalism through rigorous regulation and government oversight.

    QUALIFIED MYTH – Certainly market forces got us into a mess in the late 1920s. The interesting question is how much was Hoover’s bad policies responsible for the depression that followed and how much did various New Deal policies work to prolong the depression. That’s a big knot to untangle. Would have policies meant to alleviate economic deprivation been necessary if Hoover hadn’t have screwed up so bad?

Did Roosevelt prolong the Great Depression?

Yes. I know this from reading Eric Rauchway‘s great book The Great Depression and the New Deal. He provides a lot of data in support of the idea that Roosevelt implemented inefficient policies. Granted it takes a little bit of economic reasoning to get from that data to the conclusion that Roosevelt prolonged the depression, but its basically Econ 101 stuff so bare with me.

Roosevelt created an “alphabet soup of bureaucracies” (pg. 66) that provide direct aid to the unemployed, created public works programs, enacted price controls in agriculture and implemented various forms of industrial policy reminiscent of that sort of policy in the first World War. The CCC was created early in the administration (pg. 64) and the WPA later (pg. 67) to employ young men in projects that, Rauchway assures the reader, didn’t compete with the private sector and where jobs creating the “comforts of civilization” (pg. 68). The Public Works Administration was created in 1933 with a budget 6% of the GDP. Rauchway informs us this program wasn’t big enough to put a dent in unemployment so the Civil Works Administration was created the next year and soon employed nearly 10% of the labor force (pg. 65).

I’ll make the case that these new programs were inefficient, but to do so I need to appeal to a little economic theory. I apologize in advance. Imagine you’re unemployed and you’re looking for a job. You have a desired wage in mind and you can’t find a job. There can be two reasons why you can’t find a job. There’s not many job offers out there or all the job offers you’ve entertained haven’t been good fits for you (meaning you think you can be more productive, and higher paid, somewhere else). In either case, if you lower the wage you expect, you’d eventually find a job and the lower the wage you’d expect the faster you’d find a job.

Now, suppose the government comes in and offers a job with a “security wage” (pg. 69, basically a minimum wage). With this outside offer, you can afford to look longer for a job that pays that higher wage or you can go ahead and take the job with the government. If you take the job, you have to assume the work you do in it is just as valuable as the work you’d do in a private sector job at the same wage or you have to conclude the government job offer is inefficient ((The key assumption for inefficiency of the government job is that the government job generates at most as much value as private sector job and most likely it creates less value. I won’t spend much time substantiating this assumption, but it seems likely to be true because if the government job provided a lot of value, you have to wonder why a private firm didn’t create the job in the first place.)). If you don’t take the job and wait longer in the private sector, that’s time resources, namely you, are spent idle and that too is inefficient.

Chapter five in Rauchway’s book is devoted to showing agriculture and industrial policies in the Roosevelt administration were inefficient and because of this, they were subsequently dropped by him by his second term. The AAA was created in 1933 with the explicit instruction to decrease the “severe and increasing disparity between the prices of agriculture and other commodities” (pg. 77). The AAA asked farmers to destroy their crops and the “spectacle of … government destroying food in the midst of hunger positively hurt” (pg. 79). Needless to say, having farmers plant crops and then destroy them isn’t the best use of resources.

As for industrial policy, the NRA was created in the spirit of Hoover’s managed economy to have “management, labor, government, and consumer representatives negotiating regulatory codes” and to fix prices (pg. 83). This increased monopoly power irked businesses not in on the deal and workers complained about increasing prices, as prices are wont to do in consolidated industries (pg. 84). Beyond the political economy and backlash against the NRA, standard economic theory tells us efficiency suffers with an increase in monopoly power.

So, Rauchway has given us data that makes us think some of the New Deal policies were inefficient. Even if you don’t think the “emergency” work programs were inefficient, its pretty clear that the agriculture and industrial policy were.

Why does the inefficiency of these policies imply Roosevelt prolonged the Depression? In the macro economy unemployment is a measure of inefficiency ((As is GDP being far from its trend, which is was in the ’30s, but let’s ignore that for now.)). By any measure of unemployment, it was much higher in the 1930s than any other decade before or since. New Deal policies created inefficiencies, which created unemployment which prolonged the Great Depression.

But you don’t have to believe all this hocus pocus economic theory because Rauchway says as much when he concludes: the agriculturial and industrial policies were intended “to promote not a speedier, but a better distributed, recovery” (pg. 82). Many New Deal policies were meant to redistribute wealth not generate more of it. There’s no shame in that, but if you admit it, you’re admitting Roosevelt prolonged the Great Depression.

UPDATE: Krugman thinks Roosevelt prolonged the depression, too… by not doing enough. Who you going to believe some two-bit Nobel laureate… or me?

Labor dynamics

This is the neatest graph I’ve seen in a while (from Davis et al 2006):

The bottom numbers are the hazard rates, e.g. if you’re employed, every month you have a 2.6% chance of getting a new employer, a 2.7% chance of leaving the labor force and a 1.3% chance of becoming unemployed.

(h/t Kling)