Tuesday, March 29, 2011

Farmer on Farmer/Kocherlakota

Roger Farmer sent me this which addresses some of my discussion in this post:
Thanks to Stephen Williamson for publicizing my work and to Mark Thoma for providing a link and invitation to respond. Stephen: in addition to the paper you cited, I just finished an empirical paper on how to explain data without the Phillips Curve, two theoretical papers on why fiscal policy works in the short run (but shouldn’t be used) two papers on rational expectations with Markov switching and a piece on stochastic overlapping generations models.

The papers you mention in your blog, by Narayana and me, were both presented at a conference in Marseilles last week with not one but two Fed Presidents in attendance: Jim Bullard also gave a paper. Jim presented work that draws on the Benhabib-Schmitt-Grohé-Uribe paper on the perils of Taylor Rules. He sees a real danger of a Japan style deflation trap happening in the U.S.. Narayana gave a paper that combines a liquidity trap model of bubbles in an overlapping generations framework with a labor market based on the idea from my 2010 book, Expectations Employment and Prices. This book provides a new paradigm that drops the wage bargaining equation from a labor contracting model and replaces it with the assumption that employment is demand determined. This is the same assumption taken up by Narayana in the paper he presented in Marseilles.

The main idea is explained very nicely by one of the anonymous commentators on Stephen’s blog , who said,

“Think of it this way. With a centralized labor market, the real wage is pinned down by the intersection of labor demand and supply. With search, the labor market need not clear: the labor supply FOC is missing, and we need to add something else to close the model. One thing to add is an explicit bargaining model that effectively pins down the wage. An alternative is to say that output is demand-determined, and that the wage is the marginal product of labor at the demand determined level of output. Then firms are on their labor demand curve, but workers are not on their labor supply curve (but the beauty of search - unemployed workers will take a job at any positive wage).”

That’s exactly right. And once there are many possible labor market equilibria, there is room to close the model by bringing back the role of market psychology. That’s what I do in my work which has room for both involuntary unemployment and animal spirits; the two cornerstones of Keynes’ General Theory that are missing from the macroeconomics that emerged from Samuelson’s interpretation of Keynes.
Stephen professes not to understand the language of aggregate demand and supply. That’s not surprising given how many different ways it’s used. My own preferred interpretation is explained in a piece I wrote for the International Journal of Economic Theory in 2008.

The idea of aggregate demand and supply makes just as much sense as the notion of a microeconomic demand and supply curve as long as one works within a framework where the variables that shift one of the curves do not simultaneously shift the other. That is clearly not true in post-Lucas rational expectations models which is why the language went out of fashion. It is true in my work.
Thanks Roger.

Saturday, March 26, 2011


I am currently in Santa Barbara at a conference with some monetary economists. Other than the latest monetary economics, here is the most important thing that I learned here. Rod Garratt (UCSB), who is also from Canada, let me in on the origin of the word "hoser." Hoser was a word that Bob and Doug McKenzie (i.e. Rick Moranis and Dave Thomas) frequently applied to each other. Bruce Smith asked me on more than one occasion what it meant, but I had no idea. Where I grew up in southern Ontario, no one ever used the word.

Well, as you know, Canadians like to play hockey (certainly not field hockey; I mean hockey on the ice with skates and sticks). Sometimes we do this in someone's back yard, in which case you need to flood a patch of ground with a garden hose. After playing a game, the ice is somewhat chewed up, and it helps to flood the rink again so the ice is in good shape for the next game. Apparently there is a custom (again, not where I grew up) that the losers get out the garden hose and flood the rink. Thus, the losers are "hosers."

Randy Wright did not believe this, and thought Rod was making it up. Any confirmation or disconfirmation anyone can supply would be helpful.

Here's something else I learned. As you may not know, we Canadians love our Newfies (people from Newfoundland). They have a great sense of humor and love a good joke. Here is a Newfie joke. There are two Newfies building a house. The first Newfie notices that the second Newfie keeps throwing away nails.

First Newfie: Those nails are expensive. Why do you keep throwing some away?
Second Newfie: I've noticed that about half the nails in this box have the heads on the wrong end.
First Newfie: No no. Don't throw them away. We can use them on the other side of the house.

Friday, March 25, 2011

Indeterminacy: Farmer and Kocherlakota

I ran across this, which appears to be a conference presentation by Kocherlakota. He's not quite in central banker mode here (though there is a bit of that in the paper). It seems he's still doing research, and wants to tell us about it.

A paper that Narayana gives high praise to is this one, by Roger Farmer (UCLA). Roger is another person who does not have much time for research these days, as he is currently chairing UCLA's economics department. Roger once told me about the paper, but I have never read it, so thought I would take a look. Roger calls this an "Old Keynesian" model, which I think is accurate. There are no sticky prices and wages in sight, and this is in the spirit of models with indeterminacies, going back to John Bryant, Peter Diamond, and, as some people would have it, Keynes himself. Roger, Jess Benhabib, Mike Woodford, Russ Cooper, and others developed dynamic, quantitative versions of models with indeterminacies, but the Keynesian models that Woodford ultimately marketed to the profession and central bankers were not those ones. New Keynesian models have uniqueness, and are more in the neoclassical growth model tradition - essentially RBC models with monopolistic competition and sticky prices.

So what is going on in Roger's model? At first you think he might just be re-doing Peter Diamond. There is search and matching in the labor market, but he does not appear to be generating indeterminacies through increasing returns in the matching function, as Diamond does. Further, it seems that if firms and workers bargain over wages in the the usual Diamond-Mortensen-Pissarides Nash bargaining fashion, that we get determinacy. Further, it's apparently not sunspot indeterminacy either, as in the Farmer/Benhabib/Woodford type models. There seems to be something exogenous in there, which Roger interprets as beliefs or animal spirits, which is driving asset prices. The asset prices are apparently determined in the usual forward-looking manner, but I wasn't sure whether these beliefs were ultimately self-fulfilling or not.

In any event, apparently beliefs drive the equilibrium outcome, and we could be stuck in a high unemployment state with low asset prices. Ultimately, though, I'm not sure I understood everything correctly. Maybe someone can help me out. Further, Roger seems to want to connect his model to current events, but he might have trouble explaining why the stock market is doing well, real GDP growth is sort of OK, and the labor market is still in the toilet.

Anwyay, back to Narayana's model, which is here. The ideas seem to be coupled to his discussion of a Kiyotaki-Moore paper at this conference (see Narayana's slides, which are linked in the program). In that discussion, Narayana discusses bubbles, which in his context are essentially the types of equilibria that we are accustomed to studying in monetary models. Fiat money can have value in equilibrium, in spite of the fact that its fundamental value is zero - there is a money bubble. However, there is always an equilibrium where the bubble bursts: money will have zero value if everyone expects it to.

Narayana couples the bubble idea to a Diamond/Mortensen/Pissarides search environment, and then uses Farmer's idea to get the indeterminacy. Then he tries to get the central bank to move the real interest rate around to select among the equilibria and get us out of the low unemployment state. Two problems here: (i) We want a more serious treatment of central banking. It may be the case that monetary policy can move the real rate, but we want to know why. That's critical. (ii) Narayana (and Farmer too) slip into "aggregate demand" language. If we go back through the history of thought, we find Woodford and Peter Diamond doing it too. Why is this a mistake? "Aggregate demand" and "aggregate supply" is a language associated with a particular class of textbook macroeconomic models that were expanded and fit to data in the 1960s and 1970s in the form of large macroeconometric models like the FRB/MIT/Penn model. In the 1970s, Lucas and others convinced us (though maybe some people were not listening) that those models were not structurally invariant - we should not be using those models to think about policy interventions. The Lucas Critique had its roots in the work of the Cowles Commission (Marschak in particular I think), and it is important. Using the aggregate demand language is (i) not formally correct, either for Farmer, Kocherlakota, Woodford, or Peter Diamond and (ii) It causes backsliding. It was hard enough to convince people in the first instance that the Lucas Critique matters. Now we have to do it all over again. People will do plenty of sloppy economics without any encouragement. We don't want to hand out licenses to do sloppy economics.

Tuesday, March 22, 2011

One Last Thing

The Krugman/DeLong issue will never go away, sorry to say. Apparently the advancement of one person's political ideas is far more important than understanding or advancing economic science. I was washing dishes and listening to Bob Dylan's "Live 1966," album, which put this analogy into my mind.

In 1965 Bob Dylan took traditional American folk music and blues, mixed in Arthur Rimbaud, and harnessed the whole thing to technology. Robbie Robertson told him what electric guitar he should buy, he bought a suit in Toronto, and went on the road with some Ontario musicians, later known as the Band. Bob did not get the reaction he expected. Some people were very upset at the change, and tried to boo him off the stage. Partly they did not get the technology. But there were some people who went to those shows and thought they sounded great. Some of those people went home, bought their own electric guitars, basses, drums, etc., figured out how to use the technology, started their own bands, and wrote their own songs. Eventually a lot of people started to get it, but of course there were a few naysayers who continued to think that Bob just could not sing.

Now fast forward to 2011. Bob is still playing. He's a little wrinkly and the voice is coming out in a croak, but he's still making records and showing up for work. The guy deserves a pat on the back for still being into the music. You go to his show, and what happens? There are two guys in the back, booing. What's the complaint? These two are complaining that Bob has abandoned Irving Berlin, does not even bother to listen to Irving Berlin in order to appreciate him and, furthermore, Bob doesn't even understand his own lyrics. Who are the guys? It's Peter Frampton and Barry Manilow.

Meanwhile there is whole music festival going on in Austin: South by Southwest. Frampton and Manilow know about it, but they want to pretend it does not exist. They are certainly not in Austin participating. That festival is where the action is. The musicians are creative and interesting, and they're all talking to each other. People are listening and enjoying it. Little pieces of Bob Dylan are all over the place. These musicians have learned from him, added stuff, and gone in some entirely different directions. And they certainly are not thinking about Frampton and Manilow.

Hal Cole's Take on the Krugman/DeLong Debate

Here's what Hal Cole (U Penn) has to offer on the Krugman and DeLong affair.
One thing that struck me is that Krugman and Delong are really asking and answering a different question than many of the opposing voices they cite:

1. Can increasing government spending, especially during a downturn, increase output?
2. Does increasing government spending, especially during a downturn, make us better off?

They're answering "Yes" to the first question, based upon either assertion or simple empirics, and taking it as given that this makes us better off. The opposing voices they're citing are typically answering the second question. To answer this question you need a model, typically a quantitative model, to evaluate the welfare counterfactual. These models generally have the feature that government spending can raise output by making people poorer, but in order to a get a positive welfare impact of this spending (assuming that spending was set efficiently without the downturn and hence the marginal production of government spending is at least at its cost), requires more action from the model than the simple negative wealth effect can deliver.

This confusion about what question is being asked and answered is still a bit surprising given that the conventional RBC model, like the one in your [Williamson] textbook delivers an increase in output as a result of an increase in government spending (assuming lump-sum taxes). With marginal taxation this becomes a bit more problematic, and the extent to which government spending substitutes for private more of an issue as we move away from military spending. However, the conventional wisdom - which I take to be Barro's - holds that the multiplier is about 0.8 for military spending and perhaps a bit less than that for nonmilitary.

A lot of this confusion started with Cochrane's original comments on this issue. Cochrane wanted to rule out any model that got an increase in output from a negative wealth effect since that meant that welfare was necessarily being lowered. In the restricted class that he was considering as a result of this, government spending didn't raise output. But that's essentially by assumption.

There are a variety of the saltwater and freshwater types who are trying to re-examine the role of government spending under the circumstances that we now face. In doing so, they are using essentially identical methodologies, but somewhat different assumptions with respect to the stickiness of prices, etc. Mankiw argues recently that their may be a role if we're on the zero bound and cannot commit to future monetary stimulation in a recent piece for Brookings. Christiano et al constructs a standard neo-Keynesian model and shows that the impact can be large when we hit the zero bound. Jesus Villaverde has a paper with financial frictions and also finds that government spending can have a multiplier close to one in its initial impact. Both of the later papers don't (I think) do the welfare analysis, but that is largely because one has to take a stand on the value of the government spending, which is problematic. Mankiw's main point seems to be that there are more efficient ways to undo relative price distortions than government spending.

Monday, March 21, 2011

Krugman's Insight

Krugman is a great writer, and can nail his own worldview quite nicely:
And Brad is right: if you’ve reached the point where you don’t pay attention to anything that might disturb your orthodoxy, you’re not doing science, you’re not even pursuing a discipline. All you’re doing is perpetuating a smug, closed-minded sect.

The Chicago School

Apropos my last post, here is one from Brad DeLong, who like Paul Krugman is hung up on defunct schools of thought. Note that he thinks my colleague David Levine is a member of the "Chicago School," in spite of the fact that Levine received his PhD from MIT, just down the road from Brad's alma mater. David was supervised by Peter Diamond, a well-known liberal Democrat. David has worked with Drew Fudenberg, who is employed by Brad's alma mater, and David has also worked with Tim Kehoe, who we learned (from a commenter on my last post) is a lifelong Democrat. David also spent a considerable part of his career working in the UC system, where Brad currently finds himself.

As for the other quotes in Brad's post, the questioning of Keynesian economics is just science at work. The modern liberal agenda does not somehow hang on the issue of whether Keynes was right.

Sunday, March 20, 2011


Paul Krugman (see this for example) seems to think that (i) we can clearly identify "saltwater" and "freshwater" macroeconomists; (ii) the saltwaters are "liberal," i.e. they vote for Democrats; (iii) the freshwaters are conservative, i.e. they vote for Republicans.

First, the saltwater/freshwater distinction, while it could be applied (roughly) in the 1970s, makes no sense today. People and ideas are highly mobile in the economics profession, and ideas grow and mutate. Take Krugman's own department (the economics department at Princeton) for example. We have Alan Blinder, a solid Old Keynesian; Pat Kehoe, who went to Harvard, worked with Tom Sargent, and spent a considerable part of his career at the Minneapolis Fed and the University of Minnesota; Nobu Kiyotaki, who wrote a seminal paper with Blanchard on menu costs, also worked with Randy Wright (a Neil Wallace student), and worked for a time at the University of Minnesota; Chris Sims, also a former Minnesota professor, but a guy who clearly has Keynesian ideas; and Richard Rogerson, who is a Prescott student and Minnesota graduate. Is that a freshwater or saltwater department? Why would you even ask the question? And all those people could easily be Democrats, for all I know.

There might be people out there who are looking for a political party that represents tolerance, a sense of community and shared responsibility, and the judicious use of economic science. That political party does not exist in the United States, so we have to choose the lesser of two evils.

Paul Krugman sees injustice and would like the poor to be better off. He wants to promote the fortunes of the Democratic Party. But dissing "freshwater" economists won't aid in that goal, in part because those animals do not exist. Whatever Krugman says, the 1970s freshwater ideas have been found to be useful, and put to work in any number of ways, even in Krugman's own work. No one can kill a useful idea.

People are generally pretty polite and leave politics out of their casual conversations. But judging from my conversations with people at places Krugman would call "freshwater," there were a lot of Democrats around, maybe even a majority. A prominent 1970s freshwater economist once told me: "There are two people I can't stand. One is the President of the United States, and the other is my brother-in-law." That was during the George W. era. I think that guy would also object to most of what Krugman writes. I think it is good to seek support wherever you can get it. Maybe Krugman is shooting himself in the foot.

Saturday, March 19, 2011

The Fed and Inflation

The most recent updates on Fed policy are in Bernanke's March 1 testimony to Congress, and in this week's FOMC statement. One important piece of news from the FOMC statement is that the "extended period" language remains:
The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period.
As well, the FOMC voted to keep its QE2 program of long-maturity Treasury purchases intact. There will be essentially only one more opportunity for the FOMC to meet (April 26-27) before the QE2 program ends (the June 21-22 meeting is essentially irrelevant for the program), so the net purchase of $600 billion in long Treasuries by the Fed during the period of early November 2010 to June 2011 seems assured.

In Bernanke's Congressional testimony, he makes the case that inflation, and forecasts of inflation, are low:
FOMC participants see inflation remaining low; most project that overall inflation will be about 1-1/4 to 1-3/4 percent this year and in the range of 1 to 2 percent next year and in 2013. Private-sector forecasters generally also anticipate subdued inflation over the next few years.3 Measures of medium- and long-term inflation compensation derived from inflation-indexed Treasury bonds appear broadly consistent with these forecasts. Surveys of households suggest that the public's longer-term inflation expectations also remain stable.
Thus, the consensus projection of the FOMC is that the inflation rate should continue to be below the Fed's 2% implicit (explicit?) target, even two years out, in spite of an extended period with the interest rate on reserves at 0.25%, and the large expansion in the size of the Fed's balance sheet. Here I'm inferring that "extended" could mean as much as two years.

While it is certainly true that there is nothing alarming on the inflation front if we look at what forecasters are predicting and the yields on TIPS, maybe we should examine some other evidence. What's the goal here? Fed people, including Bernanke, make vague statements about a 2% inflation rate being what the Fed is shooting for. But what does that mean? Do we set the target at 2% in January and then say that we achieved our goal if the year-over-year inflation rate as of the next January falls between 1% and 3%? If we exceed the target are we going to have a lower inflation target for a while? I thought about the costs of inflation earlier, in this post, and would make the case that price level targeting might work well. Suppose, for example, that our target price level path is 2% inflation forever. Then, intervention by the Fed which always aims to hit the target path within a relatively short period of time (say a quarter or two) should minimize the uncertainty in real interest rates over any horizon. I think real interest rate uncertainty is a key cost of variable inflation, if not the primary one. Most debt is denominated in nominal terms, default is costly, and uncertainty is costly. Just ask Paul Krugman.

So, suppose for the sake of argument that we are shooting at a two-percent-inflation price level path, and take January of 2007 as our base year (no particular reason). The first chart shows the 2% price path target and the actual paths for some standard price level measures: headline cpi, the core cpi, and the personal consumption expenditure (pce) deflator.

In the chart, you can see that headline CPI inflation is about 1% above target, core CPI inflation is about 1.5% below target, and pce deflator inflation is about on target. Of course, what the Fed should do in this context depends on what measure of inflation it wants to focus on. The Fed, and many economists, make the case that we should focus on some core inflation meausure, either core cpi, or the pce deflator with food and energy prices stripped out. The argument is either that movements in volatile prices tend to be temporary, so we should ignore them, or an appeal to New Keynesian ideas, whereby we only care about the sticky prices, which are the non-volatile ones. Bernanke, in his Congressional testimony, takes the first route:
...the most likely outcome is that the recent rise in commodity prices will lead to, at most, a temporary and relatively modest increase in U.S. consumer price inflation...
My concerns here are the following: (i) Maybe these price increases are not temporary; with the world economy coming back (problems in Japan aside) and very strong growth in some places, resources in the world are becoming increasingly scarce. (ii) Inflation is inflation. I make the case here for looking at broader measures than core price indices. (iii) Public relations: What people see is headline inflation; indeed the prices they observe most frequently are food and energy prices. If the Fed speaks to core inflation, it can end up looking devious.

What about the future? What causes inflation? Some people, including Christina Romer, think that inflation is all about Phillips curves. According to these people, if we get more inflation than we bargained for, that would be no problem. In their view, we have a long way to climb up the Phillips curve, a huge output gap, and plenty of spare capacity. Of course Christina and her fellow Phillips-curve types seem to want to ignore the 1970s. The mid-1970s US economy was of course not identical to what we see today, but some of the same factors were at play. Recently there has been a runup in commodity prices, real GDP and employment have taken a hit, and there is an accommodative Fed working in the background, all of which were also true of the mid-70s. That earlier period of course demonstrated the prescience of what Milton Friedman said in 1968, which was that the Phillips curve was not a structural relationship that could be exploited by policymakers.

Now, Milton Friedman also said some other things. He said that "inflation is everywhere and always a monetary phenomenon," which I think is correct. Friedman was off-base though, in terms of another thing he said in 1968, which was that we could get good results if central banks were to target the growth of monetary aggregates. Unfortunately we tried that, and it did not work. Central banks have found that what works well is to target some overnight interest rate over very short periods of time (which seems to efficiently absorb very short-run shocks), and some of those central banks manipulate the overnight interest rate target to achieve some medium-term inflation target.

So why am I saying that Friedman was right about money being the source inflation? Ultimately, it is the demand and supply of outside money - reserves and currency - that determines the prices of goods and services in dollars. The problem is that the demand for outside money fluctuates in unpredictable ways. This problem is even more acute for the US, as some large and unknown fraction of US currency is not held domestically.

So what has been happening to the stock of outside money? As you might imagine, given the QE2 program, the stock of reserves is now a lot larger than in November, as you can see in the next chart. The increase since early November is about $400 billion (2/3 of the total asset purchases planned), or 154.2% at annual rates. Milton Friedman would of course think this was massive, but we have now become accustomed to seeing massive quantities of reserves on the liabilities side of the Fed balance sheet. We recognize that reserves that just sit overnight are roughly like Treasury bills, and need have no inflationary consequences if the reserves are retired in the future, for example by reversing the asset purchases.

What about the stock of currency? That has been growing substantially as well, though what we are seeing may or may not alarm you. In the last chart, you can see that the stock of currency has been growing at an increasing rate, indeed at an annual rate of 10.6% since the inception of the QE2 program. If sustained, and assuming constant velocity and 4% GDP growth, we would get something approaching 7% inflation, which I think would start to make people unhappy.

Ben Bernanke says not to worry, though. In his Congressional testimony we get:
We have all the tools we need to achieve a smooth and effective exit at the appropriate time. Currently, because the Federal Reserve's asset purchases are settled through the banking system, depository institutions hold a very high level of reserve balances with the Federal Reserve. Even if bank reserves remain high, however, our ability to pay interest on reserve balances will allow us to put upward pressure on short-term market interest rates and thus to tighten monetary policy when required. Moreover, we have developed and tested additional tools that will allow us to drain or immobilize bank reserves to the extent needed to tighten the relationship between the interest rate paid on reserves and other short-term interest rates. If necessary, the Federal Reserve can also drain reserves by ceasing the reinvestment of principal payments on the securities it holds or by selling some of those securities in the open market. The FOMC remains unwaveringly committed to price stability and, in particular, to achieving a rate of inflation in the medium term that is consistent with the Federal Reserve's mandate.
So, what could go wrong? Plenty.

1. All of the necessary conditions are there for a substantial inflation. I'm thinking of something on the order of 5% to 10%, and once it gets going it will be costly to stop it. The total stock of reserves will rise to about $1.6 trillion by the end of June, and that represents an accident waiting to happen. Right now, as Bernanke points out, financial markets are taking the Fed at its word. The margin between TIPS yields and nominal Treasury yields is not very large, reflecting modest anticipated inflation. But if people start to anticipate that the Fed will not be reducing the size of its balance sheet any time soon, and start to anticipate higher inflation, then nominal rates of return on assets will rise, making reserves undesirable to hold. The Fed can make reserves more desirable to hold by increasing the interest rate on reserves, thus cutting off the incipient inflation, but it will have a hard time doing that. Unemployment may still be high and employment growth slow, and the Fed may not want to be blamed for slowing the recovery. Further, the Fed has locked itself into a portfolio of long-maturity assets which will drop in value if short-term interest rates go up substantially. Ultimately, the Fed may not have the stomach to fight the inflation, in which case the higher anticipated inflation becomes self-fulfilling.

2. Bernanke makes it sound like the Fed has a lot of tools. Surely with so many tools, things have to work, right? However, there are really only two instruments that matter in these circumstances: the interest rate on reserves, and the quantity of assets in the Fed's portfolio.

3. If all hell breaks loose, there could be conflict on the FOMC. With a positive stock of excess reserves in the system, it is the interest rate on reserves that matters. The fed funds rate target is irrelevant. But the Board of Governors sets the interest rate on reserves. What if the Board and the regional Fed Presidents who vote on the FOMC disagree? What happens then?

Ben Bernanke wants you to think that everything is OK. Policy is proceeding in a normal fashion. We understand what is going on. I think the truth is that he is making it up as he goes along. The Fed has undertaken a risky experiment. I can see ways in which this will not turn out OK. Maybe I'm wrong, and that would be good.

Friday, March 18, 2011

Taking Mike's Advice

The blogosphere is a powerful tool. We have a technology that gives everyone access to ideas at low cost, and permits the instantaneous exchange of those ideas. The ideas can be good and bad, of course, and it takes some effort to sift through what is out there. I have been doing this for about a year now, and have learned a lot. Why do I do it? Nobody is paying me of course and, while there is some payoff in notoriety, it does not seem to be the notoriety that an academic needs. Academic economists make their names by publishing papers in scholarly journals, and influencing other academics. The ideas are vetted internally by the profession, sifted, and then are put to use in solving practical problems. That's scientific progress.

Here is what blogging does for me. It forces me on a regular basis to put complicated ideas into words and make them (hopefully) easy to understand. This is excellent discipline. The fact that those words are going to be read by a large number of people is also disciplinary. You want to have your facts right, and your arguments well-constructed, or someone will try to embarrass you. In economics seminars people can be tough as well - that's good practice for the blogosphere.

Sometimes I like to provoke. If you challenge someone's ideas and force them to defend themselves, you can get an interesting discussion going, and everyone learns something. That's the end goal. I was trained to be an educator, and this blog is just another educational tool - for me and anyone else who cares to read it.

Now, sometimes provocation does not work. Not everyone is interested in economic science. Some people have political agendas, and that need not mix well with science. I think that is part of the Paul Krugman problem, but you might disagree with me. If the political people enter the debate and misunderstand the context, then all hell can break loose, and science suffers. I have just had an experience where two groups of readers met each other, neither appreciated what the other group was up to, and nothing of value got accomplished. So I deleted that post, and wrote it off to experience.

Now, some tips for the politically active people. The events since late 2008 have been confusing and troubling. Trained economists are struggling to sort things out, so it is no wonder that everyone else is angry and looking for someone to blame. And some of those trained economists, looking to gain advantage, are quite willing to blame some of the other economists whose ideas they don't like. My messages to you are: (i) I think things are under control. Don't worry too much. Economists may bicker, but they are actually a productive lot. (ii) We are very lucky here in this country. We have stable democratic institutions, and a lot of control over those institutions if we choose to exercise it. (iii) Knowledge is power. Work to get inside the institutions. Then you can have some influence over how things are run. (iv) More knowledge helps you to understand what is worth keeping and what we should throw out. If you get carried away, you might make some errors.

Monday, March 14, 2011


My grandmother took economics from Stephen Leacock, who was better known as a humorist (or humourist) - something like a Canadian Mark Twain. Apparently Leacock was very funny in class. My grandmother thought that some people were "funny ducks," and if she could read this blog entry by Paul Krugman, (which she can't, having long departed this world) she would probably have a good chuckle. I'm sure people are guffawing today at the Minneapolis Fed, over having spent 40 years of hard work promoting ignorance.

Here we go:
Today’s freshwater economists don’t believe in Friedman-type monetarism;
First, "freshwater" is very passe. The descendants of Lucas, Prescott, Sargent, Wallace, etc., are everywhere in the world, and in some cases a couple of generations (maybe even 3 in some cases) removed from the source. Is Mike Woodford or Mark Gertler a freshwater or saltwater? Hard to tell. Second, I think we learned a lot from Friedman-type monetarism. The basic Friedman-rule idea (i.e. optimum quantity of money) is a powerful one, though there are good reasons why we think we should depart from it in practice. Targeting monetary aggregates seems a bad idea. 100% reserve requirements are unquestionably a bad idea. Some of Friedman works, and some doesn't, but you can't fault him for not being original.

The first post-Friedman generation bought into the Lucas-type argument that no anticipated shock to demand can have any real effect;
Many people who have been taught by Ed Prescott or have talked to him, have bought into the idea that "demand" and "supply" are the wrong language to be using for organizing our thinking about macroeconomics. Lucas's "Expectations and the Neutrality of Money" wasn't about "demand shocks" but shocks to the stock of fiat money, engineered by the central bank. Lucas wanted to show how one could observe Phillips curve correlations, but this Phillips curve would not be exploitable by the monetary authority. That's a powerful idea, though the monetary nonneutrality in Lucas's model is not something we take seriously any more. Lucas's paper is also a watershed in terms of its methodological contribution.

...the next cohort turned to real business cycle theory, in which recessions are basically like bad weather that both reduces a farmer’s productivity and induces him to stay indoors.
See this.

This is presumably the answer to my question about why Keynesians seem to understand New Classical models, while the New Classicals themselves apparently don’t: the Keynesians have thought long and hard about demand, the classical types have never done so, not even in the context of their own models.
I think most macroeconomists you run into these days understand the full array of models in use out there. Obviously Krugman has not been hanging out at macro conferences (or macro seminars in his own department), so he would not know that. Further, if you look through some of my blog posts, you'll see instances where I have to explain Keynesian models (New and Old) to the Keynesians.

Probably the most painful thing in Brad’s notes is Robert Lucas’s sneering dismissal of Christy Romer, whom he ridicules as someone who just made stuff up on the fly — and who then makes up his own version of Ricardian equivalence on the fly, and gets it completely wrong.
I wondered what this was all about, and looked at DeLong's notes. It's basically a lecture to Brad's undergrads, and he includes a slide with a quote from Lucas that seems to have been Bob's extemporaneous comments from a panel discussion, or some such. Funny thing to teach to your freshman class. I have a hard time imagining Bob sneering, but I'm sure it's possible. Maybe if Bob had Dick Cheney's face. In any event, Christina Romer richly deserves all the criticism she can get, if not outright ridicule. I supplied some here and here.

And finally:
But while the likes of Olivier Blanchard are indeed reconsidering their views, the people who got things completely wrong are showing about as much self-awareness and remorse as, well, Wall Street.
How can we have a discussion about this? There are some "people." Who exactly are these people? You can't debate anything if you don't name names. What is it that these people got completely wrong? What is right? What is wrong? Who is right and who is wrong, and why?

In Paul Krugman's mind lives a beast. The beast was born in his mind while he was a graduate student at MIT in the mid-1970s. The beast is Krugman's image of modern macroeconomics, and it bears no resemblance to any creature, living or dead. It certainly puts Paul in a foul mood. Maybe there is something he can take for that.

P.S.: Here's a project for an ambitious person. Take the students (i.e. completed supervised PhD dissertations) of Prescott's, the students of the students of Prescott, etc. Add up publications, citations, weight by quality, whatever (you can use REPEC for this). Now do the same for Krugman, and compare.

Sunday, March 13, 2011

Ricardian Equivalence

I thought I would add my two cents to a blog discussion about Ricardian equivalence. Here's a summary of what is going on:

1. Justin Yifu Lin, Chief Economist of the World Bank, was discussing the effects of fiscal policy. He thinks it is important to worry about the implications of a higher government deficit for future tax liabilities, and also thinks that productive government spending is good. Seems hard to argue with, right?

2. Antoinio Fatas invokes Keynesian Cross. Yes, Virginia, there is a multiplier. Who cares whether the government spending is actually well-thought-out and productive? We have an output gap, so don't worry about it.

3. Krugman weighs in. Well, we don't exactly have a multiplier. At most, it is 1. And by the way, "Ricardian equivalence types" (whoever they are) are so stupid, they don't know how their own models work.

4. Nick Rowe points out that well, in fact, if you had your choice, you might prefer the productive government spending to the dig-holes-and-fill-them-up kind.

5. Krugman replies to Rowe in a "seriously wonkish" fashion: Not so fast, Nick, you might want to dig holes and fill them up should you find yourself in a liquidity trap. Krugman marshals his argument in the form of a "little wonkish paper" he wrote in 1998. "Wonkish" here apparently means something on the level of a core-PhD-macro exam problem: an endowment economy with a Friedman-rule-type liquidity trap, and no fiscal policy in sight. The government spending implications are some words at the end of the paper.

Now, I think it is important here to separate the implications of government spending on goods and services from the financing of that spending. Ricardian equivalence relates to the financing, i.e. the timing of taxation, and I'll focus on that first.

If you have never run across Ricardian equivalence, here's the basic idea. Say the government cuts our taxes today, holding constant present and future government spending on goods and services. The tax cut does not come out of thin air - the government has to finance this by issuing debt. But the debt must be paid off sometime in the future. How? The government must increase future taxes. Consumers, being forward-looking and rational, figure out that their current tax cut is exactly offset (in present value terms) by an increase in their future tax liabilities, and they save all of their tax cut rather than spending it, so they can pay the future taxes. The government is saving less in the present, but the private sector is saving more. Everything nets out, and there is no effect on anything.

As I tell my students, Ricardian equivalence is very special. For it to work exactly in this fashion requires a lot of assumptions: lump sum taxation, no redistributive effects of taxation (across people or generations), frictionless credit markets, etc. But the idea is very powerful, and an important organizing principle for understanding why government deficits matter. At the minimum, it helps us understand the importance of the intertemporal government budget constraint, and the idea that a tax cut is not a free lunch.

What are the typical criticisms of Ricardian equivalence?

1. This is too complicated. The average consumer is never going to figure it out. According to this line of argument, consumers will see a tax cut, incorrectly infer that their lifetime wealth has increased, and we can therefore trick them into spending more. Of course, in the future, they will wake up to the notion that their taxes are higher than they would have otherwise been, and that they were too profligate in their spending at an earlier date. This hardly seems like the basis for sound fiscal policy. Like all bad behavioral economics, assuming that the average Joe or Jane is stupid puts you on a slippery slope. Maybe private citizens are so bad at making consumption/savings decisions that someone at the Treasury Department should be making those decisions for them.

2. Credit markets are not perfect. Here, the basic idea is that a tax cut in the present, matched by higher taxes in the future, is essentially a loan by the government to the private sector. The loan is the current tax cut, and you pay the government back with future taxes. The government can borrow at a lower interest rate than I can so, voila, this acts to increase economic welfare, by relaxing binding debt constraints for at least some consumers. The problem here is that the government needs to have some kind of advantage as a lender in credit markets, over private sector lenders, in order for this to work.

To think about this, we have to dig deeper, and ask what exactly a "credit market imperfection" is. Basically, we think there are two kinds: private information and limited commitment. Private information frictions in the credit market basically relate to the problem of sorting credit risks. Who is creditworthy and who is not? Here, it is hard to argue that the government has some special advantage. If someone is an alcoholic and likely to go on a bender, lose his or her job, and default on his or her private debts, their tax liabilities to the government are also in jeopardy. What about limited commitment? Here, the problem is that a person can potentially run away from their debts. In private credit markets, this problem can be mitigated by the use of collateral, but of course seizing collateral and selling it is costly, so this does not work perfectly. Here, it may be possible to argue that the government has an advantage. Possibly we can think of the power of the state to collect taxes as much more formidable than the power of Bank of America to collect on credit card debt. But this is far from clear. Through bankruptcy laws, the state attempts to minimize the cost to the private lenders of collecting on their debts, and in principle the government can set up the legal system so that its powers of debt collection transfer to private sector lenders.

Conclusion: A hardcore Keynesian wants you to think that Ricardian equivalence is a pretty flimsy idea, but it's not.

But there is another way out. Here's where New Monetarism comes in. One idea, that comes out of work by Guillaume Rocheteau, Ricardo Lagos, Randy Wright, and yours truly, for example, is that we should not get too involved with defining what "money" is. Different assets are exchanged in financial and retail transactions to different degrees. Asset "liquidity" has to do with how an asset is used in exchange, and this potentially gives rise to liquidity premia. The most obvious liquidity premium is reflected in the difference between the nominal rate of return on money (zero) and the nominal return on a Treasury bill. We can also think of the low nominal return on T-bills relative to other assets as reflecting a liquidity premium on T-bills. Now, there are events - a financial crisis for example - which can effectively hamper (or totally destroy in some circumstances) the private sector's ability to create liquid assets (asset-backed securities for example) for use in financial exchange. What should the government do? It should run a deficit and create more government debt to relieve the liquidity shortage and reduce the liquidity premia which reflect a scarcity of liquidity. But the need for the extra government liquidity is presumably temporary, so the government should plan to increase taxes in the future to retire the extra government debt, once the private sector is up to speed again. This is basically a Ricardian-type experiment, but with non-Ricardian results. Everyone is in fact better off due to the intervention.

So, it seems perfectly sensible that, during a financial crisis like the one we just had, that the government plan to run a larger deficit temporarily. But, with the intertemporal budget constraint in mind, there should also be a plan for raising taxes in the future to retire the extra debt.

But what about government spending on goods and services? What's the problem with that?

1. Implementing a temporary tax cut is far simpler and less costly than implementing changes in programs for government spending on goods and services.
2. A waste of resources is a waste of resources. We don't want to spend on anything.
3. The usual Keynesian argument is that we have an output gap. There are idle resources and we get the extra output for free. But (i) If the unemployed workers are in Nevada, and the jobs are in Washington, that is a problem. (ii) If government spending employs nurses, but the unemployed are roofers, that is a problem. (iii) If the government uses up all the idle resources, how will the private sector recover, when it takes a mind to?

I was quite happy to vote in favor of a school bond issue to rebuild the middle school at the end of my street, as it seemed to me a prime time to do so. Interest rates are low, construction costs are low, and the job can be done quickly. To me, that seemed like productive government spending, and the timing was right. It seems that Krugman and company have decided that they would like a larger government. They think that there are some things that federal and state governments do not support that they would like to see them support. I would rather have them forgo Keynesian arguments, which I think are weak, and go straight to the heart of the matter. Tell me what you want the government to do, and how you think that government activity should be financed. Then we can argue about that.

Friday, March 11, 2011

End the Fed?

Ron Paul was on Fox News this past week (see this, particularly the exchange starting at about 3:40), and seems interested in "intellectual arguments," so I thought I would do my best to help him out. I just read Paul's book End the Fed on the airplane (a quick read), and in previous post on Ron Paul I learned a lot from commenters about Paul's intellectual roots.

In case you didn't know, Ron Paul is a US Congressman who currently heads the House Financial Services Committee's subcommittee on monetary policy. I assume that this gives him some power to mobilize forces to implement his ideas. Paul is of course a vocal critic of the Fed. If there was good science backing up Ron Paul's ideas, and if the ideas were tight and well-reasoned, that would be great. Unfortunately, End the Fed which I take to be the best Paul can do in marshaling his thoughts, is for the most part bad science, consisting of flimsy arguments and some utter nonsense.

Now, to start, you should understand where I am coming from. I was not born in the United States, though I am currently a US citizen. For Canadians, coming to the United States and working here is relatively painless. For example, I look and sound like I could be from Minnesota, or the Upper Peninsula of Michigan (those people are essentially Canadian anyway - they even know how to hold hockey sticks). Sometimes I feel badly for some of my fellow immigrants, including the ones from Asia who have to struggle with the language, or those from Mexico who have to deal with this guy, but I digress. I got my first year-round job at the Bank of Canada in 1979, when I was 24. Since then I have worked full-time at the Minneapolis Fed (2 years), and have been a visiting academic at the Federal Reserve Banks of Richmond, Cleveland, Philadelphia, Kansas City, Atlanta, and New York. I currently spend an average of something less than one day per week at the St. Louis Fed, in my hometown, where my full-time job is at Washington University in St. Louis. My title at the St. Louis Fed is "Research Fellow," and I have an office over there (no window unfortunately) with my name on the door. I also know some powerful people. I went to graduate school with 2 Fed Presidents, know 4 Fed Presidents well (Narayana Kocherlakota is a rather aggressive poker player; Dean Corbae is not), and am an acquaintance of Ben Bernanke's from back in the day (e.g. we both belonged to Glenn Hubbard's NBER group for a time).

I'm not trying to boast here. As everyone knows, Canadians are trained not to do it (there are some exceptions - my friend Randy Wright has never been accused of excessive modesty). I may be slow at times, but surely after all this time hanging out with central bankers and working on the inside of their institutions I have some understanding of how central bankers think and how well they do their jobs. I also like to think of myself as an independent thinker. In this blog, I'll sometimes criticize people in the Fed when I think they need it. Some of that is in the spirit of this. Whether my ideas have any impact on how these people think about policy is a mystery to me.

Now, what is End the Fed about? The first paragraph of Chapter 10 (page 141) sums it up:
The Federal Reserve should be abolished because it is immoral, unconstitutional, impractical, promotes bad economics, and undermines liberty. It's destructive nature makes it a tool of tyrannical government.
Now, I'm sure that to some of you this sounds like a rant, but let's give the poor guy a chance, and consider the pieces of his argument.

1. The Fed is immoral. The idea here has to do with what Paul calls "printing money out of thin air." We have a government, and the government is a tyrant. The tyrant must confiscate resources in order to keep itself alive. To confiscate the resources, the tyrant can tax, issue interest-bearing debt, and also issue money, through the tyrant's central bank. When the tyrant taxes us, we can see what is going on. The thief is taking our stuff, but he or she is being pretty up-front about the whole thing. If the government borrows in order to acquire resources, then this is more indirect. The government debt issued to finance the tyrant's spending could actually just be deferred taxation (the government taxes us in the future to pay off the debt), and maybe we can figure that out, which is what Ricardian equivalance is all about. But if the tyrant simply uses its monopoly over the printing press to issue money in order to acquire goods and services, then the theft is even more indirect. As private citizens we are deprived of resources by the tyrant because the extra money issued by the tyrant drives up prices and makes our money worth less in terms of goods and services. Now, instead of a thief with the gall to steal our stuff in broad daylight, we have an underhanded, conspiratorial thief who walks off with our stuff in the dead of night. Not only that, but the thief is in league with rich bankers. Even worse.

Is the Fed immoral? Ron Paul wants you to think that what the Fed is doing is mysterious, secretive, and underhanded. We have all been hoodwinked but, according to him, he has figured it out, and will proceed to enlighten us. You can forgive Paul somewhat for the "printing money out of thin air" idea, as this is part of what is conveyed in conventional money and banking undergraduate courses. Indeed, Paul's exposure to formal economics training appears to be confined to a single undergraduate course, in which he seems to have been exposed to the money multiplier, probably the most misleading idea propagated in monetary economics. As discussed here, a central bank is best viewed as just another financial intermediary, the unique characteristic of which is that it has a monopoly on the issue of some class of liabilities. The Fed creates liabilities out of "thin air" to purchase the assets in its portfolio. A bank creates deposit liabilities out of thin air to purchase the assets in its portfolio. General Motors can create equity claims out of thin air to finance the purchase of new plant and equipment. Further, the fact that the liabilities of the Fed do not represent specific claims to anything in the future is neither here nor there. In private markets, in which Paul puts much trust, we have developed arrangements by which private firms issue claims (stock) which are not specific promises to pay anything specific in the future (dividends are discretionary). Further, private firms make no commitments about their future plans to issue more stock, or to buy back stocks, decisions which will affect the value of stock held by existing shareholders, just as decisions by the Fed affect the value of the existing stock of money outstanding. Nothing mysterious here at all.

Now, Paul seems very focused on inflation, and the resources extracted from the private sector by way of the inflation tax. It would help here to do some back-of-the-envelope calculations to get an idea of the magnitude of resource extraction. From fourth-quarter 2010 NIPA numbers, GDP was about $14.9 trillion, and total expenditures (by all levels of government) were about $3 trillion, at annual rates (seasonally adjusted), so the tyrant was extracting about 20.1% of GDP (this is all levels of government). Now, inflation has been hovering around 1% per year recently, but suppose it were 2%, which is the Fed's stated inflation target (not officially, but Bernanke says as much in public). What is seignorage, i.e. the implicit revenue the government collects, through the Fed, from the inflation tax? To calculate this, we need to know what the tax base is. Let's think of the current stock of reserves as essentially T-bills, which the Fed plans to retire in good time (to take it at its word). Then, the remainder of outstanding Fed liabilities is essentially currency (which certainly corresponds to Paul's language) which is just short of $1 trillion, so let's call it $1 trillion just for argument's sake. Then, with 2% inflation, the revenue from the inflation tax is about $20 billion per year, or 0.7% of government spending, or 0.14% of GDP. Small potatoes, and certainly not enough to justify an armed mob outside the Fed in Washington screaming "end the fed," as Paul seems to envision.

What is missing from Paul's arguments is some statement of principles about what the government should be doing. The best we get is this, on page 192:
When government grows, liberty suffers. This happens no matter what justification is given for the government programs financed.
Suppose I take this literally. Paul thinks liberty is good. More government means less liberty, therefore the optimal state of the world is one with zero government. But Paul also appears to be offended by theft, so surely he recognizes that there might be some problem in leaving policing to the private sector. Maybe he thinks that an army might be useful, if not for pursuing exploits abroad, then at least for defending us from invading Canadians. Once we recognize that there is some role for government, we are going to have to finance this government, and that will require contributions from all of us. There is then a whole branch of economics - public finance - that deals with the issue of how those contributions can and should be made, and the consequences of alternative means of resource extraction for the government. In primitive economies, where the costs of collecting taxes are high and financial markets undeveloped, it can be economically efficient for the government to generate much of its revenue with the inflation tax. In modern economies, we think not. We recognize that inflation is costly, and modern disciplined central banks keep inflation rates low.

2. The Fed is unconstitutional. I'm not a constitutional expert, by any means, but this argument seems to be coming from the same place as this, which does not quite say that the income tax is unconstitutional, but comes close. I know the idea is floating around. Get serious.

3. The Fed is impractical. Paul seems to think that the Fed is the wrong tool for getting the job done. What's the job that we want done? Apparently we want price stability, so let's take that as given. What is Paul's alternative to the Fed? He wants to go back to the good old days of the gold standard. So what's wrong with that? I discussed some of the issues here. Basically, if price stability is the goal, any commodity standard is incapable of delivering it. Here is what Paul appears to have in mind, though he is pretty vague about the whole arrangement. One of Paul's Austrian-economics heroes is Murray Rothbard, who wrote this. Rothbard thought the gold standard was a good idea, and also had a problem with fractional reserve banking. Basically, what Rothbard his in mind is some combination of the gold standard and Friedman's 100% reserve requirement on any transactions medium. Any liability used in transactions must be backed 100% by gold. Now, the key problem with this arrangement, aside from the usual difficulties with the fluctuating relative price of gold, is that there is not provision for "currency elasticity," a term written into the Federal Reserve Act of 1913. Currency elasticity is a concept you can teach to students in homework problems. Roughly, the demand for money will fluctuate due to fluctuations in various exogenous factors (time of day, day of the week, month of the year, productivity, transactions technologies, etc.). If the money supply does not accommodate these shocks, prices will fluctuate as well, and we will not have price stability. If all media of exchange are backed one-for-one with gold, then you get some elasticity due to the fact that gold can be diverted from other uses (and dug out of the ground) to use as backing for transactions media. But this necessarily implies that the relative price of gold is fluctuating and, by implication, there is no price stability. Further, restricting private financial intermediation with a 100% reserve requirement, while un-Libertarian and inconsistent with what Paul seems to stand for, is also economically inefficient - it works like a tax on financial intermediation. Theft, as it were.

4. The Fed promotes bad economics. How do you tell good economics from bad economics? Sometimes the profession gives prizes to people. There's the John Bates Clark Medal. There's the Nobel Prize. Two Nobel Prize winners were Ed Prescott and Robert Lucas, Jr. Prescott has had a long and fruitful relationship with the Minneapolis Fed, and Lucas has been a frequent visitor there. The collaboration between University of Minnesota economists and researchers working at the Minneapolis Fed produced some of the most important breakthroughs in 20th century macroeconomics. New Keynesian Economics was developed by people like Mike Woodford and Mark Gertler, who have ties to the New York Fed, and to other central banks in the world, including the ECB. Currently, there is first-rate research being done at all of the Federal Reserve Banks in the system, and at the Board of Governors in D.C., and some of those research groups would easily rank among the top 20 among working groups of macroeconomists in the world. Bad economics! What an insult! To do its job, the Fed needs to be on top of economic science, and I think it does a good job of that. A particular strength of the Federal Reserve System is its decentralization. A regional Fed President is appointed by the Board of Directors of the individual regional Fed (though the appointment must be approved by the Board of Governors), and regional Feds develop their own idiosyncratic views, with a healthy competition in ideas among the regional Feds, and between the regional Feds and the people in Washington D.C. No central bank in the world appears to be organized in a way that promotes this degree of diversity in ideas.

5. The Fed undermines liberty. What's that about? Summary:
Remember that the people who run the Fed are just regular people, as flawed as anyone else. The only difference is that they have massive power to break civilization. Any institution that can do this is by nature tyrannical and is specifically what the Constitution was trying to prevent.
I'm sure that Ben Bernanke does not look in the mirror in the morning and think of the guy he sees as being capable of breaking civilization. Central bankers may be powerful, but there's no need to go overboard here.

I have sometimes contemplated, in published papers, what the world would look like without a central bank, and how private arrangements might substitute for what the central bank does. It is important to question the existence of central banks, to put central bankers on the hot seat about their methods, and to work to improve central banking practice. However, I am convinced that, given what we know, getting rid of the Fed would be foolhardy. The science of economics is no different from any other science. Our understanding of central banking is imperfect, just as our understanding of cancer and global warming are imperfect. We have a pretty good idea about the broad outlines of what a central bank is good for, but about the details we are not sure. My judgment is that the world would be a much more unstable place without the Federal Reserve System than with it. Instability is a threat to our freedom, as events of the last 10 years should make clear. While Ron Paul might be able to convince me that we should end the Fed, my best guess is that he is not up to it.

Saturday, March 5, 2011

The US Labor Market

There appears to be some optimism given the employment report for February 2011. The unemployment rate dropped to 8.9%, and employment growth was firm. However, the labor force participation rate and employment/population ratio are at levels last seen in 1983. Though real GDP growth has been somewhat weaker than we might expect coming out of a deep recession, real GDP performance appears inconsistent with the very weak performance we are seeing in the labor market, given historical experience.

I ran across this this presentation by Narayana Kocherlakota, from a talk he gave at this conference, to what appears to be an audience of students, academics, and business people. You can watch the actual presentation, and see Narayana in professorial mode, explaining the current monetary policy predicament to people who apparently are at least up to speed in undergraduate-level economics.

Now, the basic model Narayana has in mind for organizing his thinking about labor market data and monetary policy is a kind of New Keynesian version of a Diamond-Mortensen-Pissarides (DMP)general equilibrium labor search model. Indeed, such a model has been set up and fit to data by Gertler, Sala, and Trigari. If you doubt that Narayana takes New Keynesianism seriously, read this. Now, in a model like Gertler/Sala/Trigari (GST), the "natural rate of unemployment" is well-defined. It is the dynamic path for the unemployment rate that is ground out by the model when it is subjected to some baseline series of exogenous shocks, when prices and wages are fully flexible. In the GST paper, Figure 7 shows the time series for the actual unemployment rate and the natural rate. For the experiment they did, the variability in the natural rate is quite small relative to variability in the actual unemployment rate. Conclusion? According to GST, the sticky price/wage mechanism is responsible for most of the cyclical variability in the unemployment rate. Now, these people are not doing some back-of-the-envelope calculation. This is a well-articulated model, it fits the data, and its parameters have been estimated using standard methods.

Alternatively, there is a literature that studies the properties of the DMP model absent New Keynesian frictions, including work by Andolfatto, Merz, Shimer, and Hagedorn and Manovskii. In the basic DMP model, there is not a lot to work with in terms of aggregate shocks. What Shimer considers are shocks to the separation rate (of matches between firms and workers) and to productivity. It is clear that separation rate shocks will not replicate even the qualitative cyclical features of the vacancy/unemployment rate data, so the question then is whether shocks to productivity of the magnitude observed in the data will replicate the variability and comovements of unemployment and vacancies we actually observe. Shimer's conclusion is that the answer is no.

What is the problem with the basic DMP model? Unemployment and vacancies are not variable enough in the model relative to what we observe. Why? In the DMP model, unemployment fluctuates in the face of productivity shocks due to changes in the job-finding rate driven by the behavior of firms. Higher productivity implies a higher surplus available in a match between a firm and a worker. Would-be firms respond to this profit opportunity by posting vacancies, which reduces labor market tightness, making it easier for an unemployed worker to find a job. Shimer saw the problem as being due in part to Nash bargaining, which implies that workers always receive a constant share of the surplus in a match. Some people (for example Robert Hall) have interpreted this as saying that there is too much real wage flexibility in the standard DMP model. However, Hagedorn and Manovskii say that is not correct. They argue for an alternative calibration of the DMP model, under which the typical surplus in a match is smaller, due to a higher threat point for a worker in the bargaining problem. Then, changes in productivity imply a much larger proportional change in the surplus, which gives a larger kick to vacancies when productivity changes.

Now, under the Hagedorn-Manovskii calibration, which seems to be a careful fitting of the model to the data, productivity shocks successfully predict the observed variability and comovements in observed unemployment and vacancies. In this case, there is effectively no deviation of the natural rate of unemployment from the actual unemployment rate. There is a bargaining inefficiency, but it would be hard to argue that monetary policy is about correcting bargaining inefficiencies. So, we have two very similar models, one with wage/price stickiness and one without, both fit carefully to the data, but with extremely different policy conclusions.

Narayana seems to fit somewhere between GST and Hagedorn/Manovskii. Like all good New Keynesians, he appears to think that the role of monetary policy is to correct sticky price distortions, but he's not quite sure how important they are in the current context. In his slides, you can follow his argument. He says that (i) the unemployment/vacancies ratio increased by a factor of about 2.5 from December 2007 to December 2010. (ii) In the DMP model, if match surplus had been unchanged, and given a fixed matching function, there should have been much more job creation recently than what we observed. (iii) He concludes that either (a) match surplus fell; (b) matching efficiency declined; or (c) sticky price/wage frictions are at work.

He does not seem to want to dismiss (a), arguing that taxes and extensions in unemployment insurance benefits could do the trick. This seems to me a very weak argument. There is strong evidence that tells us that match surplus has likely increased substantially. First, an important feature of the recession was the large increase in productivity that occurred. As I show here productivity is substantially higher than it would have been had it continued on the trend it was on before the recession hit. As well, in the chart, corporate profits (after taxes) are now higher than they were at their pre-recession peak. I think it is hard to argue that match surplus has not gone up substantially. Narayana seems to put a lot of weight on (c), but this also seems shaky, as his opinion is based on what appears to be Beige Book evidence on "deficient demand," whatever that is. Does Narayana have specific evidence that companies in the Ninth Federal Reserve District are shutting down because they cannot bear to reduce their prices, that unemployed people in Duluth are demanding wages that are too high, that companies in Bemidji are laying off workers rather than cutting prices to boost demand? Maybe the people who collect the Beige Book evidence are not asking the right questions.

Judging from the evidence I see, it seems the only way to reconcile the DMP model with the recent data is that there was a large decrease in matching efficiency. But that just tells us that this model is not going to be of much use in understanding our current predicament. What I argued here is that we need some better models with enough sectoral detail to capture what we mean by matching efficiency.