Tuesday, August 30, 2011

Mark Thoma Went to the Wrong Conference

Mark Thoma went to the Lindau Nobel Laureates meetings and wonders why he did not learn anything new. No offense to these people, many of whom I admire and have learned a great deal from, but this is the geriatric set, mostly. One should not expect to be enlightened about the causes and consequences of the financial crisis by showing up at Lindau. For enlightenment, Mark should have gone to the SED meetings in July, to see what the sharpest young economists in the world are doing. I'm sure Ed Prescott would agree.

Let's deal with some of Mark's specific complaints about what he thinks practicing macroeconomists have been up to:
Macroeconomic models have not fared well in recent years – the models didn’t predict the financial crisis...
I'm so sick of hearing that one I could scream. The economic agents living in a model in which a financial crisis can occur know that there is a possibility that this event can happen. But they cannot predict it, otherwise there would be an unexploited profit opportunity. Similarly, a real human being could not have used such a model to predict the financial crisis. Economists may have been unaware of some of the things that were going on in financial markets that contributed to the crisis, and some of that was not their fault, as some of those things involved obfuscation by the financial market participants involved. Failure to predict the financial crisis does not in itself condemn all existing macroeconomic theory.

How can some of the best economists in the profession come to such different conclusions? A big part of the problem is that macroeconomists have not settled on a single model of the economy, and the various models often deliver very different, contradictory advice on how to solve economic problems.
Mark obviously finds disagreement disagreeable, but that's what makes life interesting. If we all agreed, we could pack up, go home, and watch TV. There will never be a "single model" that solves all macroeconomic problems, nor should there be. We use different models for different problems, and all of those models are going to be wrong on some dimension. Intelligent economists are going to disagree about the details of what goes into the models. Science marches on.

Finally, here's an extra bit from Mark's blog post
I have little faith that the older generation will ever acknowledge the models they spent their lives building are fundamentally flawed.
Of course, every model is flawed in some sense, i.e. it is going to be wrong on some dimensions. A model is necessarily an abstraction - a simplification that helps us to organize our thinking about the world. It cannot do its job unless it leaves stuff out, and it therefore can't be right about everything.

The idea that we are surrounded by "fundamentally flawed" models is so gloomy. Look on the positive side, Mark, and recognize what the important contributions are, and how economists have built on those contributions in the last 40 years. Pay attention to the good work that young economists are doing right now, under your nose, if you care to look.

Monday, August 29, 2011

Alan Krueger

Is Alan Krueger a good person to head the Council of Economic Advisors? Here's his CV. Krueger is a successful applied microeconomist who has worked on problems in labor economics and education. I may be wrong, but I think we can characterize him as astructural, vs. structural along the lines of Heckman, Wolpin, or Pakes. Krueger would certainly have a grip on the ailments of US labor markets and US education, which certainly seem central to what the CEA should be thinking about. How any individual will behave in a policy job is hard to predict, but this seems as good a choice as any to me. Maybe you know something I don't though. I do know that this paper was a little weird.

Regular and Irregular Economics, Continued

I was pointed to this Richmond Fed article, which relates to Barro and Krugman.

Sunday, August 28, 2011

Conversations with Brad

Tyler Cowen linked to one of my posts and seems to find something in there to like. Brad DeLong does not like it.

Cowen wanted to think of what I do as "neoclassical economics." Some people like to call it "micro-founded macreconomics," and Barro recently called it "regular economics." The people I have learned from, work with, and talk to do economics - they take theory developed by other people, build on it, match the theory to data, and attempt to evaluate macroeconomic policies in a sensible way. Some of those people are sympathetic to Keynesian ideas; some of those people are critical of those ideas.

Here's what Brad has to say:
From my perspective this "neoclassical macroeconomics" is merely Hicks (1937) (or perhaps Wicksell (1898)) "plus", as RĂ¼di Dornbusch liked to say, "original errors".
This will be a theme. The pristine ideas are apparently in the classics - Hicks, Wicksell - and we have just thrown sand into the gears.

I said something in my piece about how the inefficiency I wanted to isolate was not a Keynesian inefficiency. The Keynesian inefficiency is a too-high safe real rate of interest; my inefficiency was a too-low safe real rate of interest. Here's Brad again:
In the Keynesian-or perhaps it would be better to say Wicksellian--framework, when you say that real rates of return are "too high" you are saying that the market rate of interest is above the interest rate consistent with full employment, and with savings equal to investment at full employment. Wicksell called that interest rate the "natural rate of interest" and it is relative to that natural rate of interest that Wicksellian (and Keynesians) speak of interest rates being "too high" and "too low". Thus Williamson is wrong when he say that what we have now--when the natural rate of interest on relatively safe securities is negative and the market rate of interest is not--is "not a Keynesian [or Wicksellian] inefficiency". It is precisely such an inefficiency. To claim that it is not misinterprets Keynes (and Hicks, and Wicksell), and misleads readers trying to understand what they did and did not say.
I'm taking my cue here from Mike Woodford, for example "Interest and Prices." Woodford certainly thinks that he is channeling Wicksell, though maybe Brad thinks he's not. In a Woodford New Keynesian model, monetary policy is about moving the market nominal interest rate around, and the transmission mechanism for monetary policy works through the real rate. Once you hit the zero lower bound on the nominal rate, the real rate can't go lower. That's the way New Keynesian economists inside the Fed system frame the monetary policy problem in the current circumstances. The real rate is too high, you want it to be lower, but monetary policy can't do that in the conventional manner.

Here's the interesting part. Brad is characterizing the current state of affairs and says "the natural rate of interest on relatively safe securities is negative and the market rate of interest is not." What I think he is saying is that the safe real rate of interest is low, but the relevant "market rate of interest" is in fact high. I don't think you can find that feature in any "Keynesian" framework where you would be able to correct the problem through some kind of policy Brad might want to prescribe in the current circumstances.

But whether you can find it in the General Theory or not, Brad has brought up something very useful. The fact that the safe real rate is low is intimately related to the fact that the "market rate of interest" is high. In fact, you can find this in this paper. The effect is more pronounced in the financial crisis, but I think it persists. The idea is that greater uncertainty and higher costs associated with evaluating collateral and unwinding debt acted to increase interest rate spreads - the spreads between the safe rate of interest and "market rates of interest" - reducing the quantity of privately-produced liquid assets, creating the asset scarcity that lowered the safe real rate of interest. To understand that idea, you don't need to go digging in Wicksell, Hicks, Fisher, or the General Theory. It's elucidated much more precisely in the work of Rob Townsend, Doug Diamond, and other people who worked on modern information theory, contract theory, and the theory of financial intermediation.

Brad goes on:
A second thing I think is wrong is Williamson's claim that while things could be (or perhaps should be) improved by shifting the IS curve out and to the right...
Don't go there Brad. As I said, it's not in Hicks.

The relevant question he asks is this one:
Why does pulling spending forward into the present fail while pushing taxes back into the future works?
In my post, I was arguing that the problem was a shortage of safe assets, monetary policy could not solve the problem, and we could think of an otherwise Ricardian fiscal experiment that would do the trick. I wanted to avoid talking about government expenditures on goods and services, as that would open up a whole set of issues I did not want to get into - redistribution, alternative types of spending and the government's advantages relative to the private sector, political economy, etc.

Then, Brad says:
And yet a third thing I think is wrong is Williamson's claim that "the Fed is powerless" because "swap[s of] reserves for T-bills or reserves for long-maturity Treasuries… essentially amounts to intermediation activities the private sector can accomplish as well, this will have no effect". But such swaps take various forms of duration and default risk onto (or off of) the Fed's and thus taxpayers' balance sheets and off of the private market and thus investors' balance sheets. These are different (but overlapping) groups who perceive risks differently, have different resources, and react to risks differently. The fact that the private market could undo any particular Federal Reserve policy intervention does not mean that it will.
This is a key part of my argument - i.e. under the current circumstances, quantitative easing is irrelevant. In order for asset swaps to have any effect the Fed has to have some advantage in the intermediation activity it is engaging in relative to what the private sector can accomplish. Currently the Fed has no advantage in turning long-maturity Treasury debt into overnight assets, so QE is irrelevant.

I would say go back to Hicks, Keynes, Fisher, and Wicksell, and think about them carefully: they were smart. A "neoclassical macro" that does not start from them has little chance of getting much of anywhere.
Yes, Hicks, Keynes, Fisher, and Wicksell were smart, but Keynes did not spend all of his time with his nose in Adam Smith, otherwise he would not have got any work done. Maybe someone got something wrong, and there are nuggets of insight in early work that were not passed on through the economic writings that succeeded it. However, most of what is useful from Hicks, Keynes, Fisher, and Wicksell is baked in the cake. Modern students of macroeconomics are much better off reading Lucas, Woodford, Prescott, Gertler, Gali, Farmer, Rogerson, Kehoe, Wright, Christiao, Kiyotaki, etc. from the older generations, or any number of excellent young macroeconomists. However, here is what I read the other day in Hicks's 1937 paper:
The General Theory of Employment is a useful book; but it is neither the beginning nor the end of Dynamic Economics.
Hicks was smart.

Economics Reporting

This comes from Dissecting the Mind of the Fed, by David Leonhardt, in the Sunday NYT:
But you would also find a sizable group of economists who thought the Fed could and should do far more than it was doing. This group, known as doves, tilts liberal, though it includes conservatives as well. If anything, it can probably claim a larger number of big-name economists — J. Bradford DeLong, Paul Krugman (an Op-Ed columnist for The New York Times), Christina D. Romer, Scott Sumner and Mark Thoma, among others — than the camp that believes the Fed has done too much.
Seems like he's taking a poll, and then calculating some weighted average to come up with a conclusion, with the weights determined by numbers of blog-readers.

Friday, August 26, 2011


Here is a Stiglitz talk at the Lindau meetings. He gets going, and you think it is just going to be Krugman ideas - kibitzing about modern macro in general. He makes the common error of finding fault with models that did not predict the crisis. If you build a good model of a financial crisis, the people living in that artificial environment know that a crisis can happen, but they won't be able to predict it. And you won't be able to use the model to predict a crisis in the real world either.

However, the talk then gets more interesting. It becomes clear that, when he's finding fault with models that are in common use, he has actually talked to people and tried to figure this out. The models he finds fault with are apparently New Keynesian models. He thinks that wage rigidity is unimportant, that the distortions that New Keynesians worry about don't matter much, and that we should be more concerned with financial frictions and credit. Excellent! A central banker tells him that the model used in his or her central bank has no banks in it. Stiglitz is flabbergasted. Stiglitz is now my hero.

Prescott Talk

If you have never seen an Ed Prescott talk, here is your chance. Don't pay attention to how he's saying it, just listen closely. This is interesting, just to hear how he thinks about what he does.

Woodford in the Financial Times

I agree with some of Woodford's conclusions, but was having a little trouble with his argument. First, he states
The economic theory behind QE has always been flimsy.
Yes, exactly. But then he states:
The original argument, essentially, was that the absolute level of prices in an economy is determined only by a central bank’s supply of base money.
The way Bernanke and others typically made the argument was to state that they could manipulate the relative supplies of short and long-maturity debt, and with the short end of the term structure of interest rates essentially pegged at zero, long rates would go down.

Woodford goes on to discuss how it matters whether the reserves are increased permanently or not. There is a sense in which that is correct, but I think it's also true that quantitative easing could take place in such a way that the reserves are out there forever, and it would not matter.

Woodford also states:
Uncertainty about the economic outlook is likely now the most important obstacle to a more robust recovery. The problem is not just uncertainty about Fed policy, but the fact that the Fed has become harder to “read” does not help.
I agree with that. The policy change in the August FOMC statement indeed makes the Fed harder to read, and adds to uncertainty, which is not good.

Bernanke's Jackson Hole Speech

Bernanke's speech seemed mostly on target and sensible, leaning toward growth issues, given the thrust of the conference apparently, but touching on some short-run policy issues.

Of particular note is the discussion of the August FOMC policy statement.
In light of its current outlook, the Committee recently decided to provide more specific forward guidance about its expectations for the future path of the federal funds rate. In particular, in the statement following our meeting earlier this month, we indicated that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013. That is, in what the Committee judges to be the most likely scenarios for resource utilization and inflation in the medium term, the target for the federal funds rate would be held at its current low levels for at least two more years.
The important message here is that the majority of the Committee is quite certain that there will be "low rates of resource utilization and a subdued outlook for inflation ..." for an extended period of time, in particular two years. That view seems hard to reconcile with some of the other parts of the speech, which seem to emphasize the uncertain state in which we are in. We can infer that this is the key element of contention on the committee. The dissenters may just be more uncertain than the majority.

Another key tidbit is this:
In addition to refining our forward guidance, the Federal Reserve has a range of tools that could be used to provide additional monetary stimulus. We discussed the relative merits and costs of such tools at our August meeting.
This makes it sound like there are some tools in the box that we have not tried yet, and that some of these tools will actually do something. One tool that has been used, and could be used again, is quantitative easing. As I argued here, under the current circumstances more QE is futile. The only tool the Fed currently has that will do anything is the interest rate on reserves. As Bernanke told us last year, lowering that from 0.25% is not an option, so it can only go up.

In the growth discussion, there is this:
Normally, monetary or fiscal policies aimed primarily at promoting a faster pace of economic recovery in the near term would not be expected to significantly affect the longer-term performance of the economy. However, current circumstances may be an exception to that standard view--the exception to which I alluded earlier. Our economy is suffering today from an extraordinarily high level of long-term unemployment, with nearly half of the unemployed having been out of work for more than six months. Under these unusual circumstances, policies that promote a stronger recovery in the near term may serve longer-term objectives as well. In the short term, putting people back to work reduces the hardships inflicted by difficult economic times and helps ensure that our economy is producing at its full potential rather than leaving productive resources fallow. In the longer term, minimizing the duration of unemployment supports a healthy economy by avoiding some of the erosion of skills and loss of attachment to the labor force that is often associated with long-term unemployment.
What is not clear from this is whether Bernanke thinks that, at this point in time, the Fed can do anything to bring about a faster recovery. Maybe (actually almost certainly) the FOMC is conflicted about this, and we'll have to wait for the next meeting to find out what they are thinking.

Finally, the federal government is told to get its act together:
Finally, and perhaps most challenging, the country would be well served by a better process for making fiscal decisions. The negotiations that took place over the summer disrupted financial markets and probably the economy as well, and similar events in the future could, over time, seriously jeopardize the willingness of investors around the world to hold U.S. financial assets or to make direct investments in job-creating U.S. businesses. Although details would have to be negotiated, fiscal policymakers could consider developing a more effective process that sets clear and transparent budget goals, together with budget mechanisms to establish the credibility of those goals. Of course, formal budget goals and mechanisms do not replace the need for fiscal policymakers to make the difficult choices that are needed to put the country's fiscal house in order, which means that public understanding of and support for the goals of fiscal policy are crucial.
Good. That needed to be said.

Has Politics Paralyzed the Fed?

Actually, no. But Paul Krugman says yes. This morning's NYT Krugman column starts by focusing us on Rick Perry. Perry is of course an excellent foil, and genuinely scary. But does Perry actually influence Ben Bernanke's behavior? Well, not really.
O.K., I don’t mean that Mr. Perry, the governor of Texas, is personally standing in the way of effective monetary policy. Not yet, anyway. Instead, I’m using Mr. Perry — who has famously threatened Mr. Bernanke with dire personal consequences if he pursues expansionary monetary policy before the 2012 election — as a symbol of the political intimidation that is killing our last remaining hope for economic recovery.
So, since Perry is only "symbolic," what exactly is the substantive nature of the political pressure on the Fed? Krugman mentions two things: (i) the dissent by three members of the FOMC on the last policy decision; (ii) some public statements by Paul Ryan about dollar debasement and such. Now, (i) Dissent within the FOMC is certainly not political; that has to do with the internal workings of the Fed. I don't think you can make a case that Plosser, Kocherlakota, or Fisher were motivated by political pressure (see this, this, and this). (ii) There is nothing much new about members of the House criticizing the Fed. Ron Paul has for a long time been arguing that we should abolish the Fed, which seems to make even members of his own party want to run the other way. I don't see any evidence that monetary cranks have altered Fed behavior.

So much for the politics. The heart of Krugman's post actually has to do with how Bernanke's behavior as Fed chairman matches up to what Bernanke was proposing in 2000, as a recipe for Japan's problems at the time.
Mr. Bernanke suggested that the Bank of Japan could get Japan’s economy moving with a variety of unconventional policies. These could include: purchases of long-term government debt (to push interest rates, and hence private borrowing costs, down); an announcement that short-term interest rates would stay near zero for an extended period, to further reduce long-term rates; an announcement that the bank was seeking moderate inflation, “setting a target in the 3-4% range for inflation, to be maintained for a number of years,” which would encourage borrowing and discourage people from hoarding cash; and “an attempt to achieve substantial depreciation of the yen,” that is, to reduce the yen’s value in terms of other currencies.
Then, Krugman states:
So why isn’t the Fed pursuing the agenda its own chairman once recommended for Japan?
Let's just deal with the accuracy of that statement for now. Of course, if you have been watching what the Fed has been doing since late 2008, you know that the Fed has been following Bernanke's 2000 Japan agenda remarkably closely. The Fed has tripled the size of its balance sheet, purchasing large quantities of long-term government debt, as well as mortgage-backed securities and agency securities. The Fed's policy rate (the interest rate on reserves) has been set at 0.25% since late 2008, and the FOMC has just announced that, barring some extreme and unexpected circumstances, that will continue for almost two years. How much more extended can you get? The only piece of policy that differs from the Japanese agenda is the 3-4% inflation target. Bernanke and other Fed officials are on record as stating that their inflation target is 2%. While one could find sound reasons why this target could be higher, there is nothing the Fed could be doing that it has not already done that could actually increase the inflation rate in the United States.

Krugman argues that the Fed is paralyzed and politically intimidated. Neither is the case. The question we want to ask under the current circumstances is the following. Are there actions the Fed could be taking that would make us better off? Krugman would like you to believe that there are things the Fed could be doing, Bernanke knows what they are, but wrongheaded politicians and some dissenters on the FOMC are preventing him from executing the agenda. I don't think that's right. Under the current circumstances, the Fed is powerless, and the dissenters are right.

Thursday, August 25, 2011

Understanding Irregular Economics

Paul Krugman has written a post that encapsulates his thinking on macroeconomics - how he thinks other people do it, and how he thinks it should be done. His post is a comment on Barro's WSJ article that I discussed here.

Let's take this apart. First paragraph:
As Glasner says, there’s something deeply weird about asking “where’s the market failure?” in the face of massive unemployment, huge unused capacity, an economy producing less than it did three and a half years ago despite population growth and advancing technology. Of course there’s some kind of market failure, which means that there’s nothing at all odd about asserting that better policy can yield free lunches.
We cannot observe a market failure. To deduce that a market failure exists, one needs a model. Given that we cannot observe market failure by looking at the state of the economy, we also can't say what a "better policy" is. Again, for that we need a model.

Second paragraph:
More generally, the existence of business cycles is hardly a trivial feature of real economies. You can try to explain those cycles in terms of “regular economics” — that’s what real business cycle theory is all about — but that effort has been a dismal failure, even if the practitioners refuse to admit it. The desperate efforts to find something Obama has done that explains why the economy plunged are in effect a demonstration of the hollowness of that whole approach.
Yes, real business cycle theory uses regular economics. But so does all of modern Keynesian theory. The people who worked on coordination failures - Bryant, Diamond, Cooper, Farmer, Benhabib - all used regular economics. So do the New Keynesians - Woodford, Gali, Gertler, etc. Krugman himself uses regular economics. But what was the "dismal failure" of real business cycle theory? Kydland and Prescott introduced a quantitative methodology that is still in wide use. The basic theoretical framework (due as much to Solow, Cass, Koopmans, Brock and Mirman, as to Kydland and Prescott) was expanded upon and used widely in the study of optimal taxation, time consistency, and other things. Further, Woodford adapted it to produce New Keynesian theory. Seems there is plenty of success in there.

Third paragraph:
But I want to add something more: why, exactly, are we supposed to have such faith in “regular economics”? What is the compelling evidence that the vision of a competitive, efficient economy allocating resources to the right uses is actually a good description of the world we live in?
Regular economics is not restricted to the study of competitive and efficient economies. Much of modern macroeconomics deals with externalities and the distortions caused by taxation and information frictions, among other things. The study of efficient economies is only a tiny part of what macroeconomists actually do.

Fourth paragraph:
I mean, it’s a lovely model, and one I, like everyone else in economics, use a lot. But I would not have said that it’s a model backed by lots of evidence. We do know that demand curves generally slope down; it’s a lot harder to give good examples of supply curves that slope up (as a textbook author, believe me, I’ve looked); and it’s a very long way from there to the vision of Pareto efficiency and all that which Barro wants us to take as the true economics. Realistically, imperfect competition, market failure, and more are everywhere.

1. "It's a lovely model" clearly means basic RBC, e.g. Kydland and Prescott. Why the focus on this particular model? Even if we focus on that model in particular, you can't say it's not backed by evidence. That was the whole idea. Go back and read Kydland and Prescott.
2. "it’s a very long way from there to the vision of Pareto efficiency and all that which Barro wants us to take as the true economics." Where does Barro say in his piece that everything is Pareto efficient?
3. Yes, we can find plenty of imperfect competition, market failure, and more. But regular economics can and does deal with all of that stuff. What is the problem here?

Fifth paragraph:
Meanwhile, there’s actually a lot of evidence for a broadly Keynesian view of the world. Not, to be fair, for fiscal policy, mainly because clean fiscal experiments are rare. But there’s huge evidence for sticky prices, lots of evidence that monetary shocks have real effects — and it’s hard to produce a coherent model in which that’s true that doesn’t also leave room for fiscal policy.
We have a fairly good characterization now of how prices behave - the frequency of price changes for particular goods and services. That evidence does not entirely square with modern Keynesian models, and we have search models which can deliver the features of price behavior we observe, but where money is in fact neutral. It does not follow obviously from the observed behavior of prices that the short run non-neutralities of money actually result from the pricing behavior of firms. The big gap in Keynesian theory is that it does not deliver on the elements that are key to how it works: Why are contracts set in nominal terms? Why are prices changed infrequently for some goods and services? What would make a firm unwilling to change its price but more than willing to incur the costs of changing output and employment?

Last paragraph:
In short, there’s no reason at all to consider microeconomics the “real” economics and macroeconomics some kind of flaky impostor. Yes, micro is a lot more rigorous — but if it’s rigorously wrong, who cares?
Note how he uses "macroeconomics." He means the macroeconomics that is spooned out to poor unsuspecting undergraduates in many undergraduate principles and intermediate macro books, which is indeed flaky. This is not the macroeconomics of most practicing macroeconomic researchers, the macroeconomics taught in PhD programs or the macroeconomics of the economists who advise many policymakers. It's not too much to expect that macroeconomists be rigorous - just like everyone else.

Regular Economics

Barro has a piece in the WSJ which appears to be part of a series of critical opinon pieces on Keynesian economics. It's better than the last one.

I like the idea of emphasizing "regular economics" vs. Keynesian economics. The 1970s revolution that Lucas started was principally a drive to make macroeconomics regular, by using tools developed in other fields in economics to make sense out of macroeconomic problems. This was initially hard for Keynesians to swallow, but it did not take long for them to catch on, and by the 1980s they were doing the same thing.

Modern Keynesian coordination failure models (not so popular today) and New Keynesian models (very popular) are in fact regular economics - most of the time. Everything is explicit, you can see how it works, and you can quantify things, such as the effects of government policies. Then, we can go about evaluating these models. Why is this assumption there and not another one? Is this parameter measured correctly? How well do these models fit the data?

Much blogosphere Keynesian economics is not regular economics, though. What is driving much of this are the misleading notions that come from some undergraduate textbook macro - the free lunches that Barro is complaining about. Arguments are typically couched in terms of "deficient aggregate demand," by which an irregular Keynesian means "output is below trend." Not all of the blogosphere is like this though. Paul Krugman, who often engages in irregular Keynesian economics, can on occasion be regular, in which case you can actually take it apart and see how it works.

Now, since Barro is regular, you can also take his arguments apart and see what makes them tick. For example, Barro states the following:
Ironically, the administration created one informative data point by dramatically raising unemployment insurance eligibility to 99 weeks in 2009—a much bigger expansion than in previous recessions. Interestingly, the fraction of the unemployed who are long term (more than 26 weeks) has jumped since 2009—to over 44% today, whereas the previous peak had been only 26% during the 1982-83 recession. This pattern suggests that the dramatically longer unemployment-insurance eligibility period adversely affected the labor market. All we need now to get reliable estimates are a hundred more of these experiments.
We know that unemployment insurance (UI) has incentive effects. Any serious model of unemployment will deliver the result that an increase in UI benefits - working through a reduction in search effort by the unemployed, or a tendency of the unemployed to become more picky about the jobs they will accept - will imply a higher unemployment rate and longer average duration of unemployment spells. The key question is how large the effect is. We might also be interested in how the size of benefits matters relative to the duration of benefits, for example.

Barro is too careful to stick his neck out, but he certainly seems to be indicating that he thinks the effect could help in a significant way in explaining what we are observing in the data - i.e. he thinks the effect is large. He also indicates that we should have to see more data to sort this out, but I don't think that is true. We actually have a lot of cross-country data for countries with very different UI systems, for example, and some previous experience with the extension of benefits in the US. Indeed, I would be surprised if there were not many published papers that address the question directly. Anyone know?

P.S. Here is some work on this, arguing the effect is small. The source of the citation also makes the point that it is important to look at the recent data.

Tuesday, August 23, 2011

Common Sense and Macroeconomics

This WSJ article by Stephen Moore was ridiculed by Paul Krugman and David Glasner as anti-intellectual, and Noah Smith used the article in an attempt to ridicule Ed Prescott.

Moore's basic argument is that Keynesian economics does not satisfy the rules of common sense, whatever that is, and he gives some specific examples. Moore's discussion is somewhat confused. In particular, he seems to think that modern macroeconomics and Keynesian economics are synonymous. He also argues that, in analyzing unemployment insurance we should only be thinking about the incentive effects, and apparently not about why the government should be supplying the insurance, the role of UI as a transfer, or how the financing of the transfer could matter. However, it's not surprising to me that Moore is confused, and I have some sympathy for the poor guy.

Indeed, one could get the idea from reading the blogosphere that modern macro is dominated by the legacy of Keynes, when the truth is that most practicing macroeconomic researchers are not spending their time thinking about multipliers and the paradox of thrift. There are indeed ways in which Old Keynesian economics - basic Keynesian cross and IS/LM - defies common sense, i.e. the common sense that comes from standard microeconomics.

What is common sense anyway? It has to be something most of us possess, clearly. Don't put your hand in a fire. Don't cross the street without looking both ways. The latter piece of information came to me along with: Don't run out between parked cars. There were no parked cars where I lived. Everyone parked in the driveway or the garage. Therefore, that did not apply to me. Looking both ways before crossing the street must also not apply to me. When I was 8 years old, I crossed a highway without looking and was run over by a car. I have looked carefully ever since.

When I first took economics, here is what common sense was for me. It was the tail end of the hippy era and I thought that people in suits were greedy bad people out to steal from the poor. Rent control was a good thing as it took money from greedy landlords and gave it to poor apartment-renters. Wage and price controls seemed like a good way to control inflation, though I did not quite understand what it was that was inflating. And so on.

In microeconomics, my professor convinced me that a simple supply/demand apparatus determining equilibrium prices was a useful way to think about price determination, and he showed us how this apparatus could be used to make sense out of actual prices and quantities that I could observe. Greedy people could actually be getting rich and performing a useful social function. Rent controls could actually harm everyone - rich and poor - in the long run. Wage and price controls could screw up the allocation of resources in a severe way. There is no free lunch. Everything comes at a cost.

Then I took macroeconomics which, in terms of the machinery I had built up in taking micro, made little sense. If competitive equilibrium with market-clearing prices was so useful in microeconomics, why couldn't we do that in macro? What is this paradox of thrift? What's this nonsense about the multiplier free lunch? Why did I have to un-learn all the micro I had learned in order to do macro? It took another 6 or 8 years and many readings and re-readings of work by Lucas, Wallace, Prescott, and others, before everything finally made sense.

There is nothing easy, natural, obvious, or common-sensical about Keynesian economics. If you try to do it properly, or try to turn it into a story, you come up with more questions than you can answer. Why would we think that firms would shut their doors or would-be workers would remain unemployed because of an unwillingness to lower their prices and wages, respectively? Why would a firm, faced with an increase in customers, increase its output and not its price? Why would many economists, faced with phenomena that appear very un-Keynesian, and with plenty of sophisticated tools available, revert to the rustiest old contraption in the shop?

Friday, August 19, 2011

Liquidity Traps, Money, Inflation, and Bond Yields

What is a liquidity trap? This is really two questions: (i) What is the "liquidity" that is getting trapped and (ii) What is the "trap" all about? In Old Keynesian economics and Old Monetarism, we think of the financial world in terms of two assets: interest-bearing assets and money. Money is the stuff that is used in transactions - liquidity - and private sector economic agents are willing to substitute money for interest-bearing assets in response to changes in the nominal interest rate. The nominal interest rate is essentially a measure of the scarcity of money as a medium of exchange. Monetary policy is about swaps by the central bank of money for interest bearing assets, or the reverse, and the attendant effects of those actions. One of those effects is a short-run liquidity effect. A central bank swap of money for interest bearing assets tends to make money less scarce as a medium of exchange in the short run, and the nominal interest rate falls.

But what if the nominal interest rate were zero? In that case, money is not scarce as a medium of exchange, so that money and "interest-bearing" assets are essentially identical, in which case central bank swaps of money for other assets are irrelevant. That's Grandma's liquidity trap.

Now, as Hicks said,
The General Theory of Employment is a useful book, but it is neither the beginning nor the end of Dynamic Economics.
Modern economists have expanded on Old Keynesian and Old Monetarist ideas and made them more precise. For example Ricardo Lagos, building on earlier work by Charles Wilson, tells you exactly what Grandma's liquidity trap is. It's basically a Friedman rule idea. There are many ways for policy to support a Friedman rule, i.e. a zero nominal interest rate forever. If there are many policies that support a zero nominal interest rate forever, that's also saying that there is a subset of monetary policies, among which the choice is irrelevant, i.e. if the central bank conducts certain kinds of asset swaps, then nothing changes, i.e. there is a liquidity trap.

Why am I calling this Grandma's liquidity trap? During the National Banking era, there were recurrent banking panic episodes, and it is most useful to think of these as currency shortages, i.e. "liquidity" shortages. The way to correct a currency shortage is through conventional central bank actions - open market purchases of interest-bearing assets and discount window lending. This is just the logical extension of standard day-to-day central banking practice: Target a "degree of liquidity scarcity," i.e. a nominal interest rate, and then accommodate shocks to the private sector's demand for liquidity. This view of the world is consistent with how Friedman and Schwartz thought about the Great Depression. Basically, in Grandma's world, the idea is that the central bank does not need to be worried about the sources of fluctuations in the demand for currency. All that matters is that these fluctuations be accommodated appropriately with the standard tools available to central bankers.

I am convinced that this is not the way we want to think about the recent financial crisis, or about how monetary policy should be conducted given current circumstances. We are not in Grandma's liquidity trap.

Here's a better way to think about it. Think of the world as having two kinds of liquidity: currency and other liquid assets. The other liquid assets include bank reserves, Treasury bills, long maturity government debt, asset-backed securities, bank loans, etc. - all the assets that are somehow useful in some form of exchange (retail, wholesale, financial) either directly, or because they can be transformed by financial intermediaries into some asset that can be used in exchange. The "other liquid assets" of course have different characteristics, and are used in different ways in exchange. Risk, including maturity risk, is important in determining the prices of these assets (relative to each other), and different liquid assets will have different liquidity properties, reflected in how they are used in exchange. An important concept here is the "liquidity premium" which we can measure as the difference between an asset's market price, and its "fundamental," i.e. the price it would trade at, based on the stream of future payoffs the asset is a claim to, if the asset were not useful in exchange.

Bank reserves - the accounts of financial institutions with the Fed - are a key liquid asset, as reserves are used daily in the clearing and settlement of a very large volume of transactions. However, it takes a very small quantity of reserves to support this extremely large volume of financial trade - the velocity of circulation of reserves within a day (pre-financial crisis) is typically humongous. Currently, the financial system is awash with reserves, to the point where the marginal value of reserves in financial transactions is essentially zero. The interest rate on reserves (IROR), which is currently 0.25%, is higher than the interest rate on 3-month T-bills, which is currently 0%. Thus, T-bills command a higher liquidity premium than do reserves, as they are actually more useful in financial exchange (inside and outside the US).

The key liquidity trap - the contemporary liquidity trap - the Fed is faced with currently is that all of the other liquid assets are now essentially identical, from the point of view of Fed asset swaps. The Fed cannot make reserves more or less scarce as a liquid asset through swaps of reserves for other assets, and therefore has no hope of moving asset prices. The Fed can swap reserves for T-bills or reserves for long-maturity Treasuries all it wants, but because this essentially amounts to intermediation activities the private sector can accomplish as well, this will have no effect.

An important point to note is that the contemporary liquidity trap, in contrast to Grandma's liquidity trap, has nothing to do with the zero lower bound on the nominal interest rate. Remember that the short-term safe nominal interest rate tells you how scarce currency is relative to other liquid assets. The IROR could be 2%, 5%, or 8%, so that currency is scarce, but there would still be a contemporary liquidity trap if reserves were not scarce relative to other liquid assets.

As I have discussed in earlier posts, the only relevant policy instrument the Fed has, so long as the stock of excess reserves is positive, is the IROR. Thus, the only lever the Fed has is the ability to make currency more or less scarce relative to other liquid assets, and that is the avenue by which the Fed can control the prices of goods and services. Here is where the zero lower bound on the IROR comes in of course. At the zero lower bound, the Fed cannot achieve a higher price level, except through talk about the future.

Now, to put this in context, let's look at some traditional monetary measures. The first chart shows the stock of currency over the last five years. You can see that the currency supply grew significantly during the financial crisis; this is likely driven by overseas demand, but it is hard to know - we don't know exactly where US currency resides or what it is doing. Over the last two years, and particularly this year, currency has been growing at a reasonably brisk pace (more on growth rates later).

The key thing to note here is that, under the current regime (positive stock of excess reserves), the currency stock is not directly under the Fed's control. The Fed determines the total stock of outside money (currency + reserves) and financial institutions, firms, and consumers determine how that is split between currency and reserves. The stock of currency could be rising because the demand for it is rising, or because reserves are looking less desirable for financial institutions. This of course matters - in the latter case this would be inflationary, in the former case not.

The next two charts show M1 and M2, again for the last 5 years. These charts are very interesting. Both M1 and M2 show recent large spikes. Further, if we look at year-over-year growth rates in currency, M1, and M2, these are all getting large, as we see in the next chart. The twelve-month growth rate in M1 now exceeds 20%, and growth rates in M2 and currency are at or close to 10%. Allan Meltzer should be having a cow.

Of course, this is where Grandma's liquidity trap comes in. Monetary aggregates are constructed to include private and public liabilities that are widely used in exchange by firms and consumers, under "normal" circumstances. But circumstances are not normal - a checking account is now a convenient short-term store of value with no associated opportunity cost. Thus, these spikes in M1 and M2 need not be associated with more inflation. However, I don't think we know enough to tell.

But why the spikes in M1 and M2 in the last weeks? That may have something to do with what you see in the last chart. This one shows, again for the last five years, nominal and real (i.e. TIPS) yields on 10-year Treasuries. These yields have also fallen significantly in the last weeks. This reflects a scarcity of other liquid assets, presumably because of a general "flight to quality" in world asset markets.

Now, if other liquid assets are becoming more scarce, it would make sense that we should see growth in financial intermediation, reflected in growth in M1 and M2, as the private sector creates more assets in the "other liquid assets" category. However, it could also be that there has been a decrease in financial intermediation not reflected in M1 and M2. For example, there could have been a shift out of "shadow banking" into conventional commercial banking, but unfortunately we do not measure shadow banking activity.

The scarcity we are observing is not a traditional currency scarcity. As such, we can't correct the scarcity by using conventional central banking tools - open market operations in short-term government debt and discount window lending. Neither can we correct it through "quantitative easing." We cannot ease anything through swaps of reserves for long-maturity debt, as that cannot make reserves relatively less scarce under the current circumstances. But the inability of monetary policy to correct the liquidity scarcity problem has nothing to do with the zero lower bound on short-term nominal interest rates, as the key problem is a contemporary liquidity trap, not Grandma's liquidity trap.

How can government action mitigate the liquidity scarcity? If monetary policy cannot do it, that leaves fiscal policy. But there is a tendency, particularly in the blogosphere, to frame the problem in Old Keynesian terms. In this view, we are facing Grandma's liquidity trap, the LM curve is flat, monetary policy doesn't work, so shift the IS curve instead. Further, unemployment is very high and persistent, so it might seem natural to have the government employ people directly by spending more. But the problem here is financial, and it's not a Keynesian inefficiency associated with real rates of return being too high; in fact real rates of return are too low given the scarcity of liquid assets, which produces large liquidity premia.

One way to solve the problem would be to have the Treasury conduct a Ricardian intervention, i.e. issue more debt with the explicit promise to retire it at some date in the future. If the future arrives, and we still have a scarcity, then do it again. This requires a transfer, or a tax cut in the present, and leaves the present value of taxes unchanged, but the result is not Ricardian because of the exchange value of the government debt issued.

What's the difficulty here? Well, the US government apparently has a very difficult time making decisions on fiscal matters, and seems not to like commitment, so what I am proposing is just not feasible politically. You might think it convenient if the Fed could conduct limited types of fiscal policy, but that requires giving the power to tax to unelected officials, and that seems a bad idea.

So where does that leave us? The key financial problem facing us is a scarcity of other liquid assets, not a traditional currency scarcity. The Fed is powerless to solve that problem; the Treasury could in principle solve it but cannot. For now, the Fed can only monitor the economy for signs of a more serious inflation. Some of those signs may already be there, for example in currency growth, though it is hard to tell what is driving that.

Thursday, August 18, 2011

Plosser Elaboration

You can see Charles Plosser explaining himself here. He is quite thoughtful, and I did not hear him say anything I disagreed with. There's a funny part where his interviewer asks him if the Fed is getting too "mathy." See what you think.

Tuesday, August 16, 2011

Rick Perry and Texas Research Universities

This story is interesting on two dimensions. It deals with incentives in academia, and with someone who tells us he wants to be President of the United States. The first I heard of this was from one of my friends, who moved from a well-regarded public university in Texas to a similarly well-regarded public university in another state, and this issue seemed to play a role in the move.

This article in the Washington Post lays out the details of the story, which involves Texas Governor Rick Perry, his friends/contributors in the business community, the Board of Regents of the Texas State University System, and the University system itself. You can also find information in this Huffington post piece. Basically, the Texas Public Policy Foundation (TPPF), working in part through Jeff Sandefer, a Texan with personal and financial connections to Governor Perry, proposed Seven Solutions to what they perceive to be problems with the Texas State University System. It appears that the Governor shares the opinions of the TPPF and Sandefer on this matter.

In Texas (as in other states) the Governor can exercise a lot of power, if he or she chooses to, over how the state's public universities are run. In particular, Governor Perry appoints the Board of Regents. The media articles I link to above tell us that Perry is indeed excercising the power granted him. He has bought into the ideas of the TPPF, he is a man of action, and he wants the ideas implemented.

Indeed, officials at Texas A&M took the first step in implementing the first of the Seven Solutions, which essentially involves creating a bottom line for each professor in the university. Teaching a lot of students is a good thing. That brings in tuition dollars and enters as a plus. Earning a big salary is a bad thing. That enters as a negative. A grant is a good thing. That brings money into the university and enters as a plus. Not surprisingly, as you can see in the resulting spreadsheet, most of the Texas A&M Professors end up in the red.

A university that followed the Seven Solutions would look like the following. There would be a small number of adjunct faculty with low salaries, teaching a large number of students, and with salaries determined by scores on student evaluations. Research might be done at this university but, if so, it would be funded externally, and the research operation would be completely separated from the teaching operation. Indeed there is no reason for research and teaching to be conducted in the same physical location. One could imagine a Texas "university" system with separate teaching institutions and research institutions, though if the research institutions were totally dependent on external funding, it's hard to see why the state of Texas needs to be involved with those.

This is a particularly bad model for higher education. First, teaching and research are in fact complementary activities, both for the individual professors who work in research universities, and for the institutions themselves. It is important to have teachers in the classroom who are at the cutting edge of research in their respective fields, as those are the people with the best knowledge of what students should be learning, and who can best guide the curriculum in general. Further, one role of a university is to fund research directly - for example, the university may have better information about the individual researcher than does an outside funding agency.

Second, while students are perceptive and can pick up on some forms of misbehavior by professors - poor preparation, tardiness, lack of respect for students - in other ways students can be fooled. A student may find a course easy because they have an aptitude for the work. A course may also be easy because the professor is not challenging the students, and therefore not teaching them much. The student may find it hard to tell the difference, so the professor is rewarded for being unambitious. The student is none the wiser until he or she tries to apply what was learned in class, which may be years later. Thus, student evaluations, while they convey some information, need to be treated with a grain of salt.

A key problem with the Seven Solutions, and the top-down approach coming from the Texas Board of Regents, is micromanagement. In a university system, management starts at the department level. A good department chair understands who is good at teaching, who is good at research, allocates people accordingly to the correct tasks, and provides them incentives in terms of salary, teaching load, and other benefits. Deans set broad goals for departments. Provosts set broad goals for Deans. Presidents of universities set even broader goals and raise money, and in a state university system the Board of Regents oversees the whole thing. It is a very bad idea to have the Board of Regents - the people at the top of the system with little information about what is happening at the lowest level - trying to manage the faculty directly.

Now, the troubling part of this, with regard to Governor Perry, is that this episode reveals something of an impulsive nature. Some of your friends tell you something, and you act on it, apparently without much regard for the views of experts in the field. In this case, the friends seem to be zealots, whose ideas run counter to accepted practice among university administrators. Governor Perry is also on record as supporting the teaching of "intelligent design" in public schools, and appears to appoint people to the State Board of Education who are favorable to that. We might read into this a disregard for science in general.

In any case, we need to know more about Rick Perry. If we look at the current Republican Presidential field, and follow the money, this person is the likely nominee. Obama is currently looking weak, so Perry stands a good chance of being President of the United States. Right now, that looks pretty scary.

Monday, August 15, 2011

Commitment, the State of the World, and Dissent

Here are some more thoughts with regard to my previous three posts (this one, this one, and this one.)

As academics, our policy arguments take place in the following way. We agree on what the state of the world is, but we may disagree on what model we should use to guide policy. Typically our arguments are in terms of the merits of the models at hand. Which model is better? Once we agree on that, then we can determine an operating rule for policy that tells the policymaker what action to take given any possible state of the world.

Policymaking on the FOMC seems not to work like that. Some of the non-economists on the committee are not aware of all the models available and how they work. The trained economists may have very different views concerning the merits of the models at hand. Over time, what seems to make the decision-making process work is to have the argument over the state of the world rather than over the theory. Pre-financial crisis, the question would be framed as follows. The FOMC members took as given that they did the right thing at the last FOMC meeting. The question for the current meeting was whether the state of the world was worse, better, or about the same relative to the last meeting. If things were worse, they would move the target for the fed funds rate down 1/4 point; if things were better, they would move up 1/4 point; if things were about the same they wouldn't do anything. Easy.

Post-financial crisis, things are not quite so easy, as now we supposedly have some more tools (I say supposedly because this is Bernanke's claim; I actually don't think so). Primarily, quantitative easing is on the table, and so is "extended period" language. But the policy decision is still framed in the same way. Is the state better or worse? Based on the answer to that question, the FOMC either tightens or eases. Then the question is how to do the tightening or easing.

Now, go to Bernanke's explanation for why the FOMC voted for the QE2 program in November 2010, i.e. this piece in the Washington Post. He discusses the dual mandate and some broader issues associated with the state of the world. Here is the important part:
The FOMC decided this week that, with unemployment high and inflation very low, further support to the economy is needed.
What Bernanke is telling you is that the FOMC has a decision rule, and for purposes of communicating with you, that decision rule takes account of inflation and unemployment. Unemployment is bad, and more inflation is good in this case. That's not the unemployment or inflation that he or someone else is forecasting, that's the unemployment and inflation we are actually observing. Then, he is telling you that the state of the world dictates that the FOMC should ease, following which he lays out the QE2 plan:
With short-term interest rates already about as low as they can go, the FOMC agreed to deliver that support by purchasing additional longer-term securities, as it did in 2008 and 2009. The FOMC intends to buy an additional $600 billion of longer-term Treasury securities by mid-2011 and will continue to reinvest repayments of principal on its holdings of securities, as it has been doing since August.

So, it's possible that the FOMC might now think that QE2 did not work, in which case maybe they want to try something else. However, Bernanke seems to think it worked, at least that's what he said in this speech in February. As of the end of the QE2 program, Jim Bullard certainly thought the program worked, as did other Fed officials.

Thus, in terms of Bernanke's own publicly-stated criteria for what directs easing and tightening, Kocherlakota tells us the state is worse. In November 2010, the FOMC agreed that the state of the world directed them to ease. They eased, and according to them the easing worked. The state of the world is now better, so why ease further?

I think macroeconomists agree broadly on issues of commitment. The decision rules of policymakers need to be simple enough for the public to understand, and policymakers need to behave in ways that are consistent with their publicly-stated policy rules. If there is a change in a decision rule, that needs to be clearly-communicated.

In the case of last week's FOMC decision, there was certainly no statement that the FOMC was thinking about the world in a different way. Thus, presumably the decision rule has not changed. If that is true, than the FOMC's decisions should be consistent with what it has been doing. But Kocherlakota argues that is not the case, and I think he is right. A decision that may appear to make the Fed's behavior more predictable actually makes it less so. Instead of asking why the dissenters on the FOMC voted the way they did, we should be asking why the other people on the committee voted the way they did. And we should not have to ask that. We are now more confused, and that is not good.

Saturday, August 13, 2011

Kocherlakota Elaboration: An Update

As you might expect, Mark Thoma and Paul Krugman are criticizing Kocherlakota's dissent on the recent FOMC statement, and his subsequent elaboration.

Thoma accuses Kocherlakota of cherry-picking the data, then proceeds to cherry-pick. Krugman points out that the employment/population ratio is still low, but it's not so different from where it was in November 2010, which seems consistent with Kocherlakota's argument. Thoma thinks the Fed has not really committed:
Finally, this is not a rock solid commitment from the Fed. This is their view of the most likely path for the federal funds rate, they have not said this is what they will do independent of how the data evolve. All they have said is that economic conditions are likely to warrant this outcome.
I'm afraid not, Mark. As I argued here, something very dramatic will have to happen for them to go back on their word.

Finally, Krugman states this:
So this isn’t fact-based policy. The Fed dissenters are obviously looking for excuses to pursue tight policies; they’re looking at the facts only in search of support for their prejudices. As the old line goes, they’re using evidence the way a drunk uses a lamppost: for support, not illumination.
This is of course grossly insulting. He's not accusing Kocherlakota of faulty reasoning. Apparently his crime is that he has an unstated agenda, and he's picking the data to support his narrative. Actually, that's Krugman's crime. Narayana, as long as I have known him, has been honest and straightforward, even when it hurts. Whatever it is that he is thinking, he'll let you know, as I think he has done here.

Friday, August 12, 2011

Kocherlakota Elaborates

Here is Narayana Kocherlakota's explanation for his dissent with respect to the most recent FOMC decision. As I mentioned in the comment section of my previous post, Kocherlakota actually has some New Keynesian (NK) leanings, and his dissent is entirely consistent with an NK view of the world. In this view, a Taylor rule dictates monetary policy. In Taylor-rule land, only the current state of the world, defined by the current inflation rate and the current unemployment rate, matters (though some Taylor rules have anticipated inflation on the right-hand side). On those terms, the current state actually looks better than the state in November 2010. Inflation is higher and unemployment is lower, which should dictate a less accommodative policy, not a more accommodative one.

Thus, if we buy NK, Kocherlakota's dissent makes sense. However, this guy, for example, seems to think that Kocherlakota is ridiculously hawkish and callous toward the unemployed. Seems he just wants to enforce New Keynesian consistency though.

I live in non-NK land (or willing-to-be-convinced-but-still-unconvinced-NK-land), so if Kocherlakota's dissent makes sense to me, and it can make sense in NK-land, it must be good, right?

Wednesday, August 10, 2011

The FOMC: There is good commitment, and there is...

Yesterday's FOMC statement came with some unexpected news, but in retrospect I think we should have seen it coming. Here is the key change in policy:
The Committee currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.
Thus, the key change is applying a date to the "extended period" language that has been in the statement since late 2008. "Likely to warrant" is about as clear a commitment as I think will ever come from the FOMC. Compare this to what was in the November 2010 statement where QE2 was laid out:
...the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month. The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.
That program was executed exactly as planned. There was some language in there to hedge against wild unforeseen circumstances, but once the FOMC gets this specific it has to stick to its guns or risk destroying its credibility.

A key problem here, of course, is that not everyone is on board, and the dissenting group - Fisher, Kocherlakota, Plosser - includes two of the most capable economists on the committee. Outside of Dudley, the New York Fed President, only one of the voting regional Fed Presidents, Evans (Chicago), voted in favor of the policy change. I think the dissenters are on the right side of this issue.

Given the current operating regime the Fed is in, with very large quantity of excess reserves in the financial system, and the interest rate on reserves (IROR) determining short-term nominal interest rates, the experience is not there, nor is there agreement on what theory to apply, for the Fed to understand well what it is doing. It is also very difficult for people trying to understand what the Fed understands, to know what is going on. In this context, how can the FOMC be so certain of itself as to commit two years in advance?

Further, it seems the outcome the Fed would hope for is one where inflation increases, the interest rate on reserves increases commensurately, and the Fed proceeds to sell off assets so as to normalize the state of its balance sheet, with zero exess reserves. Committing to IROR = 0.25 for two years risks two outcomes that seem equally bad (if we believe that 2% inflation is optimal). One is the too-high-inflation outcome: People anticipate high inflation, reserves start to look much less desirable, and the high inflation is self-fulfilling. The other is too-low-inflation: People anticipate low inflation, the reserves look more desirable, and low inflation is self-fulfilling. The first scenario is something that I have been worried about. The second scenario was a concern of Jim Bullard, and Narayana Kocherlakota. I think both are possibilities, i.e. there are multiple equilibria.

Fed officials like to talk about "anchoring expectations." In this circumstance, the kind of FOMC statement that would anchor expectations would be something like: "We anticipate raising the fed funds rate target (actually the IROR target, but what the heck) as observed and anticipated inflation warrants. Currently, we think we are on a path on which inflation will increase."

Sunday, August 7, 2011

Pre-FOMC: A Guide to What's on the Table This Week

The upcoming FOMC meeting this week is a critical one, and an important test for Ben Bernanke. In terms of something we can agree the Fed should be concerned with - inflation - here is what is going on. The figure shows the cpi, the core cpi (cpix in the figure) the pce deflator, and core pce deflator (pcex in the figure). I've taken January 2005 as a base period here. This is obviously arbitrary, but that choice is instructive in this context. The figure also shows a 2% trend path, which represents the Fed's quasi-explicit target. I'm not defending the 2% inflation target, and I don't think the Fed can defend it either, relative to 0%, 1%, 3%, or 4%, for example.

In June, the headline cpi was 3.1% above the 2% trend, the pce 1.6% above, the core cpi 0.4% below, and the core pce 0.6% below. Now, if the FOMC wanted to be consistent with previous FOMC statments and public minutes, and if it were looking only at that picture, there would be grounds for tightening. While core price indexes are a little below where they should be, an increase in the relative price of food and energy has persisted since 2005, and there is no good reason to expect that relative price shift to go away. As I noted here, the FOMC is on record as being focused on headline inflation, and rightly so.

Of course, the FOMC is not looking just at that picture. Indeed, unless you have been living in an isolation tank for the last several weeks, you know that all hell appears to be breaking loose. The Fed is bound by law to speak to its dual mandate, and I think there is little dispute about the role of a central bank in promoting financial stability.

On the real side, the last quarterly GDP numbers were weak, and there is nothing very promising in the monthly data. Things could be worse, but residential construction is still in the toilet, with no pickup in housing starts; consumption expenditure is weak; employment is growing but at a slow pace; the employment/population ratio is also still in the toilet.

In financial markets real and nominal yields on US government debt have recently dropped significantly. Stock prices are falling. Sovereign debt problems in Europe are going unsolved. Our federal government's inability to develop a coherent fiscal plan has the potential to get us into trouble.

How do we make sense out of this, and what should the Fed be doing about it? First, suppose that the turmoil in financial markets is only temporary, but nevertheless forecasts indicate that real growth (absent Fed action) will continue to be more sluggish than we had expected. Should the Fed be doing something? No, there is nothing it can do. The interest rate on reserves has been at 0.25% since fall 2008, and the "extended period" language could be in the FOMC statement until eternity. The Fed could do QE3, but QE2 was irrelevant, so another round would have no effect either. Even if you thought quantitative easing worked as the Fed claims, long-maturity Treasury yields are already low. The problem is not that safe long bond yields are too high.

On the financial front, the big story is uncertainty. One story you hear is that firms are not investing because they are uncertain about future government behavior. While we appear to have a weak executive branch and a goofy legislative branch, I think the uncertainty people are concerned with is rooted in debt problems - in this case sovereign debt. Europe's sovereign debt problems have the potential to produce calamity on the order of what we saw in fall 2008. Mitigating that is our previous experience, and the fact that policymakers have had more time to figure out where the vulnerabilities lie.

A key problem is that low US Treasury yields reflect a scarcity of safe assets in the world. US debt, in spite of our recent fiscal fracas and S&P downgrade, is still viewed as a safe haven. I mentioned above that inflation, if anything, is currently too high in the US, but a continuation of the current financial conditions, or a worsening of the situation in Europe, would ultimately lead to a downward price level adjustment in the US, due to the increase in demand for the liabilities of our consolidated government. Effectively, there is a liquidity problem, but it is not one that can be solved through standard open market operations - this is not a currency shortage (as for example in the Great Depression) but a shortage of consolidated-government debt (i.e. the net debt of the central bank and federal government combined).

What to do about the liquidity shortage? The Fed can of course use conventional discount window lending, but currently the liquidity problem is mainly in Europe, not in the US. There is another tool, though, which is the Fed's swap facilities with foreign central banks. These played an important role during the financial crisis, were discontinued, and then renewed again in May 2010. As far as I can tell, these swap lines are still open, but are currently not being used, and I don't know why. Maybe someone has information on this.

In any event, I'm very curious to see what comes out of this FOMC meeting. Reassuring words? Something big? There is certainly a lot at stake, including the credibility of the institution.

Saturday, August 6, 2011

Repy to Krugman Part II

A few more words on the fracas associated with this, before we move on to the serious problems facing the world. I was mulling over Krugman's comments, in particular this one:
It’s funny in this case, because Quiggin is in fact a prominent economist, Williamson not so much.
So, it seems that, in Krugman's mind, prominence is a good thing, I have not so much of this thing, and therefore I must be some kind of lesser being, who should not be so uppity.

Now, prominence actually might be bad. I could have a prominent zit on the end of my nose, in which case I'm just hoping it will go away quickly. Prominence can also be good. Ed Prescott is a prominent person in the profession in part because of the students he has trained, and the students that were trained by the students of students, etc. On that dimension, Prescott is prominent, Krugman not so much.

Lady Gaga is prominent. A few weeks ago I actually shared an airplane with this person, on the way back from Sydney. The security guy at the Sydney airport clued us into this fact, though he seemed to be somewhat embarrassed by what she had on. Lady Gaga then left my mind, until we landed in LA. My wife and I were walking the 20 miles to US immigration, and there she was. Conservatively dressed, this time (for Lady Gaga), but with 5-inch heels and a funny hat. Not sure how she walked the 20 miles without breaking an ankle. Now, you might think being prominent in the sense of Lady Gaga would be a bad thing (for her) in an airport, but she actually seemed to be quite into it. Even the walk to immigration was a performance, and she seemed to like the attention.

Now, Lady-Gaga-prominence is a particular kind of prominence. Many people know her name, but most of us could not say much about her music or what ideas are floating around in her head. Krugman has some Lady-Gaga-prominence, but of course there's more depth to it than that. People who know who he is are aware of the ideas in his head, and he has followers. We can say that he is influential. But what of that influence? People can be prominent and propagate bad ideas, as Krugman does on a regular basis. John Quiggin is apparently prominent - he has written many words, and there is obviously a market for that stuff. On the basis of my reading of "Zombie Economics," I would argue that he is also propagating bad ideas. So much for prominence.

Now, here's the core of Krugman's idea here:
...if you look at how many freshwater macroeconomists have responded to Keynesian arguments in this crisis, you find over and over again that they resort to assertions of privilege — basically, I am a famous macroeconomic expert and you aren’t — rather than really addressing the issues...But in any case, this is never an appropriate way to argue — least of all at a time like this, when events have strongly suggested that a lot of work in economics these past few decades, very much including the work on which these guys’ reputations are based, was on the wrong track.
The problem with this, as with Quiggin's book, is that it is so vague and general as to be vacuous. There was "a lot of work," done by "these guys." It was on the "wrong track." "These guys" are apparently "freshwater economists," but guys like that are very hard to identify these days. 1970s ideas have evolved to the point where the labels "fresh" and "salt" don't apply to anyone in particular.

Krugman is badly confused. The ideas of some of "those guys" are in fact in the core of some of the work that he is so proud of. His liquidity trap paper uses a cash-in-advance construct, popularized by Lucas. His paper with Eggertsson is a direct descendant of Kydland and Prescott (1982), by way of Rotemberg and Woodford.

This kind of criticism is just misguided flailing-about, and it certainly can't accomplish anything useful.

Friday, August 5, 2011

Reply to Paul Krugman and other Rabble-Rousers

Well, the blogosphere is a strange place, full of funny people. Sometimes people ignore me. Sometimes I hit a nerve and an organized mob goes to work. I wrote this, John Quiggin replied with this, and Paul Krugman felt the need to stand up for his comrade with this.

Like everything I've done in this blog, I've learned from this. People have come back with interesting comments, and we've worked through some ideas. I learned something about some work that exists out there, and about some interesting people.

Krugman seems to think that I'm somehow "pulling rank" on John Quiggin. Well, the story of my life is being misunderstood, so I'm accustomed to this. In my original post, I'm just giving you a factual account of how I happened to be reading Quiggin's book. If I tell you that, previous to getting the book in the mail, I had never heard of John Quiggin, that's certainly not his fault, nor does that mean that I think the guy is a dope, or that I'm somehow better than he is. Holy crap! Who am I anyway? I have not worked at any institution (save perhaps the Minneapolis Fed) that anyone would rank in the top 20 in the world. I typically work on things that people find somewhat esoteric and cultish. I grew up in small-town Ontario and was educated in public schools. My parents were well-educated, but basically lived hand-to-mouth.

Quiggin is a very interesting case. He has a strong technical background, and has an enormous number of citations for a paper published in 1982 that seems to have been written when he was an undergraduate. That paper is in decision theory, which I find hard, and he has published other work in that vein. The man writes, and has written, an enormous amount. His keyboard must be on fire.

The bone I have to pick is with his damn book. There are some theorists that see modern macroeconomics and like it. It fits together like things they already know, the language is similar, and one can see how standard economics can be put to work to understand aggregate phenomena. Quiggin is not like that though. If you read Zombie Economics and this paper, with names redacted, you would not know it was the same person, as Zombie Economics reads like fringe economics (Austrians, Post-Keynesians, etc.). In fringe economics, the game is dismissing things you know little about, and offering little that is actually constructive.

Quiggin and Krugman indeed have a lot in common. They are smart people, with demonstrated success in particular branches of economics, but with little or no knowledge of what makes modern macroeconomics tick. In part, they seem to think that modern macro is a tool of right wing conservatives and therefore needs to be destroyed. Let me assure you that modern macro is not inherently a tool of any particular ideology. It just forces you to work harder to find the appropriate role for government. But the result is better policy.

Wednesday, August 3, 2011

The Great Divide is Between Thoma's View of Reality and Reality

I saw this piece by Mark Thoma a while back, yawned, and went on to something else. When I got back from vacation, in the course of catching up and following links to my posts, I discovered that there is actually a reference to one of my posts hiding in there (more on that later), so I thought it was worthwhile to rebut his nonsense.

We'll skip the bad analogy at the beginning of the piece. Mark's point is essentially a standard one. Academics are out of touch with the "real world" and basically spend their time staring out the window thinking deep thoughts for their own entertainment.

Apparently, as we keep hearing from the usual rabble-rousers, academics failed to predict the financial crisis, so what are they good for anyway? Further,
...a few practitioners saw the housing bubble coming.
Who were those people anyway? They must have made a killing! Did they predict the turning point in housing prices in 2006? Did they predict that prices would fall from their peak by about 35% (or whatever)? What exactly is a bubble anyway? Do those practitioners have a good definition of this phenomenon? What do they think caused it? Do they know when the housing market will turn around if they are so smart?

What's at the root of the problem?
Economics has lost the connection between the practitioners and the academics. This may have something to do with the desire among economists to become more of a science – a heavy focus on theory and math is the result.
So, we would do much better if we did not use the tools that Newton, Pontryagin, Bertsekas, Arrow, Debreu, Samuelson, Solow, Nash, Harsanyi, Selten, Hurwicz, Maskin, Myerson, etc., gave us. Then we could better communicate with those in the trenches and the world would be a better place.

There is no great divide between academics and practitioners in economics. When I go to conferences and go out to give seminars I meet people working in many different fields in economics. Plenty of them move around among institutions where people think about policy and advise policy makers, institutions where the main job is doing frontier research and educating students, and consulting work. Go to any business school and you will find loads of applied economics that people find useful not only as an organizing tool to make sense of the world but for making money. In business schools applied economics sometimes is called finance, accounting, or marketing.

One of the great successes in economics is auction theory. This started off in a quite abstract, mathematical fashion, and ultimately expanded into empirical work in the hands of people like Robert Porter, Ken Hendricks, and Harry Paarsch, for example. Auction theory has been used successfully in the design of auctions of bandwidth and oil leases, and there are currently economists working for Yahoo and Google who use their knowledge of auctions to contribute in important ways to making those companies profitable.

Closer to home, there are plenty of high-level academics who are willing to get their hands dirty at regional Federal Reserve Banks and at the Board of Governors in Washington. In this respect, there is far more interaction between academics and the Federal Reserve System than was the case 10, 20, or 30 years ago, thanks in part to the pathbreaking work done by people like John Kareken, Art Rolnick, Tom Sargent, Gary Stern, and Neil Wallace at the Federal Reserve Bank of Minneapolis in the 1970s.

Now, here's where Thoma mentions me:
Academic economists do evaluate policy proposals theoretically and empirically, and they do provide forecasts of the economy. But forecasting in particular is not the main focus of their efforts, , and they’ve all but ignored – even looked down their noses upon – forecasters and practitioners in the government and business communities. They are often viewed as data grubbers who use old-fashioned models and techniques, and are thus unworthy of attention from high-minded academics.
Notice what he's up to. Mark fancies himself as a very high-minded and fair individual who would never stoop to name calling, but he's essentially calling me an arrogant twit. If you go back and read my post, you'll see that it was a response to some interview comments by Larry Meyer that included this:
My views would be considered outrageous in the academic community, but I feel very strongly about them. Those models [modern macro models] are a diversion. They haven’t been helpful at all at understanding anything that would be relevant to a monetary policymaker or fiscal policymaker. So we’d better come back to, and begin with as our base, these classic macro-econometric models.
Meyer essentially disparages post-1980 modern macroeconomics as a waste of time, and I thought that deserved a response. The gulf there is not a problem for modern macro, it's a problem for Meyer, who has not taken the time and trouble to understand what macroeconomists are doing and how he can make use of it. Why Mark Thoma can't see that is beyond me.

John Quiggin

[For an expanded (and published) update on this post, see this.]

John Quiggin is an Australian economist who some of you might be familiar with as the author of "Zombie Economics: How Dead Ideas Still Walk Among Us." Currently he is having a bit of a dustup with the Australian wing of the Rupert Murdoch empire.

I knew absolutely nothing about John Quiggin, until someone asked me to write a short review of Zombie Economics for the Journal of Economic Literature. The timing was good, as I was about to leave for Australia to give a plenary talk at the Australian Conference of Economists in Canberra in July. I could read the book on the plane (though a trip from St. Louis to Chicago would actually be sufficient) and might actually come across the man himself, or news of him, at the conference.

By the time I got to Canberra, I had read Zombie Economics, and had written a draft of my review which panned the damn thing (more on that later). I was a little lost at the conference as none of the Australian economists I know showed up, but Pete Klenow was there, and I sat down at dinner with Max Corden, who is one of the most engaging people I have run into in my life. Between courses at dinner, various awards were presented, and at one point we got to an the annual award of Distinguished Fellow of the Economic Society of Australia. Previous recipients included my dinner companion Max Corden, Trevor Swan (he of the "Solow-Swan model"), and Murray Kemp. Who did the 2011 award go to? John Quiggin.

What is Quiggin's claim to fame? His early work is an odd mix of agricultural economics and decision theory, but he seems to have distinguished himself mainly in public policy. He writes regularly in the mainstream media, writes a blog, and Zombie Economics appears to have sold well.

Now, what is Quiggin up to in Zombie Economics? Roughly, Quiggin is the Australian farm team in the Krugman/Thoma/DeLong league. Quiggin argues that there are five key "zombie ideas" that have been used by conservative economists for ideological purposes. The financial crisis has showed us that, without question, these ideas are wrong. Nevertheless the ideas, like zombies, continue to walk. If you read the book, you'll see why it could sell well in airports. However, I would recommend Life by Keith Richards (which is the last book I bought in an airport) over Zombie Economics any day. Keith is much more interesting, and the economics is better.

So, what are the zombie ideas? They are:

1. The Great Moderation.
2. The Efficient Markets Hypothesis.
3. Dynamic Stochastic General Equilibrium
4. Trickle-down economics
5. Privatization

The Great Moderation: Quiggin is a little confused on this one, as the Great Moderation simply characterizes a set of properties of US aggregate time series. From about 1985-2007, inflation was lower and less variable, and real GDP was less variable about trend than had been the case previously. Quiggin is certainly correct, though, in finding fault with those (Ben Bernanke included) who wanted to argue that the Great Moderation was due to a regime change in economic policy. If policy was so great, it should have done a better job over the last four years.

The Efficient Markets Hypothesis: For Quiggin this is "the idea that prices generated by financial markets represent the best possible estimate of the value of any investment." Here, Quiggin is badly confused, but maybe the finance practitioners are not helping him out much. Market efficiency is simply an assumption of rationality. As such it has no implications. If it has no implications, it can't be wrong.

Dynamic Stochastic General Equilibrium: Quiggin claims that this is "the idea that macroeconomic analysis should not concern itself with economic aggregates like trade balances or debt levels, but should be rigorously derived from macroeconomic models of individual behavior." I can hear you snorting with laughter. Why is "but" in that sentence? Like the "efficient markets hypothesis," DSGE has no implications, and therefore can't be wrong. Indeed DSGE encompasses essentially all of modern macroeconomics. Which of our models is not dynamic, with uncertainty (and therefore stochastic), and with some equilibrium concept. Indeed, many of them incorporate trade balances and public and private debt. Granted, some of our models were not so helpful in making sense of the financial crisis. But others were, and some of the models that were not helpful could be (and are being) modified so that they are.

Trickle-down economics: This one puzzled me. For the previous three zombie ideas, Quiggin is confused, but I could see where the confusion might come from. However, while the words "trickle-down economics" are familiar to me, I have a hard time associating that idea with the mainstream ideas of any academic economists. On some level, it seems obvious that economic growth benefits all residents of a country. Whatever my skill set, I would rather ply my trade in the United States than in Malawi. While there may exist serious barriers to economic mobility in the United States that we should be addressing, the financial crisis does not somehow point out some serious deficiencies in how economists think about the income and wealth distributions.

Privatization: Here, Quiggin offers a litany of government privatization efforts gone awry. If I wanted to, I could take this evidence as supporting the hypothesis that government is really bad - so bad that it can even screw up privatization.

So, the heart of economic thought is a set of zombie ideas that should die a miserable death. But to be replaced by what? Quiggin is pretty vague about this. He thinks that "heuristics and unconsidered assumptions inevitably play a crucial role," and that economics should focus "more on realism, less on rigor." Eureka. We need some sloppy, realistic, heuristic models with unconsidered assumptions.

It's unfortunate that some of the people who write so much about economics for the general public spend so little time reading about what economists actually do, and attempting to understand it. No wonder people are confused.