Category Archives: Mark Thoma is Indispensable

Brad DeLong’s Questions

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His post is here. I will insert my answers.

Why is housing investment still so far depressed below any definition of normal?

In the U.S., politicians shifted from punishing mortgage lenders for making type II errors (turning down borrowers for loans that might have been repaid) to punishing them for making type I errors (lending to borrowers who might default). In addition, politicians interfered with the foreclosure process. This kept markets from returning to normal, and it further discouraged mortgage lending. What good is the house as collateral for a loan in a world where the government keeps the lender from getting at it?

Why has labor-force participation collapsed so severely?

I believe that this is a trend, amplified by the cycle. Many workers are facing stiff competition from foreign labor and from capital. At the same time, the non-wage component of compensation has gone up, because of health insurance costs. These factors put extreme downward pressure on take-home pay for many workers, and they have responded by dropping out of the labor force.

Why the very large spread between yields on safe nominal assets like Treasuries and yields on riskier assets like equities?

I lean toward a Minsky-Kindleberger answer. During the Great Moderation, confidence in financial intermediation grew. We thought that banks had discovered new ways to manufacture riskless, short-term assets out of risky, long-term investment projects. Then came the financial crisis, and distrust of financial intermediation soared. This made it harder to convince people that you could provide them with riskless, short-term assets backed by risky, long-term projects.

Why didn’t the housing bubble of the mid-2000s produce a high-pressure economy and rising inflation?

It took place in the context of the long-term trend to displace many American workers with capital and with foreign labor. The bubble took us off that trend and the crash put us back on it.

To what extent was the collapse of demand in 2008-2009 the result of the financial crisis and to what extent a simple consequence of the collapse of household wealth?

Great question. It appears that the collapse of household wealth is a sufficient explanation. But if so, then what was the point of TARP and the other bailouts? Of course, putting on my PSST hat, I would reject a phrase like “collapse of demand.” I would say instead that in the wake of the financial crisis, the psychology of existing businesses was that it was a good time to shore up profits by trimming the work force, and the psychology of entrepreneurs was that it was not a good time to try to obtain funding for new businesses.

Why has fiscal policy been so inept and counterproductive in the aftermath of 2008-9?

Not a question that I can answer, given that we disagree on what constitutes inept and counterproductive.

Why hasn’t more been done to clean up housing finance (in America) and banking finance in Europe)?

Politicians care about what happens on their watch. That is why you can count on them to bail out failing financial firms (“Yes, we should worry about moral hazard. But risk some sort of calamity because of a visible financial bankruptcy? Not on my watch.”) That is why you can count on them not to institute major financial reforms. (“Of course, we need a new design here. But do something that could cause short-term disruption to some constituents? Not on my watch.”)

Incidentally, I diagnosed the “not on my watch” bias toward bailouts way back in 2008. Also in September of 2008, I wrote,

Five years from now, we could find ourselves with no exit strategy. My guess is that we’ll be pretty much out of Iraq by then. But it would not surprise me to see Freddie and Fannie still in limbo.

You can read Robert Waldmann’s answers here. Pointer from Mark Thoma.

David Andolfatto on Asymmetry

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He writes,

the labor market is a market for productive relationships. It takes time to build up relationship capital. It takes no time at all to destroy relationship capital.

Pointer from Mark Thoma. Note that this should make firms hesitant to fire workers, because of the cost of having to re-fill the position if it turns out that it was needed. I believe that this reinforces the asymmetry.

Noah Smith’s Crazy Utopian Idea

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He writes,

I want to move back toward a society where the hard work of an unskilled laborer is considered worthwhile in social interactions, regardless of how many dollars it brings home. I want to move back toward a society where being a good parent or a friendly neighbor earns as much respect as making a hundred million dollars on Wall Street.

In other words, I want our “democracy” back. We need to redistribute respect.

Pointer from Mark Thoma. To realize this utopia, the mainstream media would have to respect people who belong to the tea party. That is why the idea struck me as crazy.

Money and Inflation

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Owen F. Humpage and Margaret Jacobson write,

Over the short run—a year or two—excess-money growth explains very little of the changes in the GDP deflator. If excess-money growth explained all of the annual price changes, the dots in the scatter plot below would line up along the 45-degree line, and all price movements would be inflation—strictly a monetary phenomenon. Instead, the dots are spread about, showing almost no correspondence between the annual change in the GDP deflator and excess-money growth. The simple correlation coefficient is only 0.10. Moreover, the typical annual dispersion of price changes from excess-money growth is about 4 percentage points, but there are some enormous outliers. Many of the largest deviations occurred during the Great Depression and the Second World War, both highly disruptive and uncertain economic events. Likewise many dots associated with the recent Great Recession years also seem well off the mark. Clearly, central banks do not have much control over aggregate-price movements on a year-to-year basis.

Pointer from Mark Thoma.

Some comments.

1. To see what the authors did, start with MV = PY, and solve for P. P = V(M/Y). Convert to approximate percentage changes by taking logs of both sides: growth rate of the price level equals growth rate of velocity plus the difference between the growth rate of money and the growth rate of real output. The latter is what they call excess money growth.

2. Most economic models do not allow for such wide fluctuations in velocity.

3. I think this supports my view that the Fed does not have firm control over macroeconomic aggregates.

4. The authors say that in the long run, inflation can be linked to excess money growth. I gather that long-run velocity growth is much more stable than short-run velocity growth.

Two Views of Obamacare

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1. The Washington Post editorial page:

Republicans, many of whom claim to favor market approaches to expanding health-care coverage but oppose excluding patients with preexisting conditions, can’t credibly balk at the natural results of competition organized under those very principles. No one can expect low premiums and near-unlimited service, particularly in a system designed to spread costs around so that the sick and the old can finally obtain decent health coverage from private insurers. That’s not a mistake. It’s economics.

Pointer from Mark Thoma. I wish that he had also linked to John Cochrane’s piece, below.

Of course, I do not think this is very good economics. Spreading costs around is best done through subsidies and taxes, not through mandating that some people buy inappropriate coverage so that others can enjoy subsidized coverage. Also, I am getting really tired of folks referring to government-designed health insurance sold through an exchange as a “market approach.” This approach eliminates what I see as the main benefit of markets, which is the process of innovation and creative destruction.

2. John Cochrane:

Only deregulation can unleash competition. And only disruptive competition, where new businesses drive out old ones, will bring efficiency, lower costs and innovation.

Now that’s economics. As to health insurance, Cochrane writes

Health insurance should be individual, portable across jobs, states and providers; lifelong and guaranteed-renewable, meaning you have the right to continue with no unexpected increase in premiums if you get sick. Insurance should protect wealth against large, unforeseen, necessary expenses, rather than be a wildly inefficient payment plan for routine expenses.

People want to buy this insurance, and companies want to sell it. It would be far cheaper, and would solve the pre-existing conditions problem. We do not have such health insurance only because it was regulated out of existence. Businesses cannot establish or contribute to portable individual policies, or employees would have to pay taxes. So businesses only offer group plans. Knowing they will abandon individual insurance when they get a job, and without cross-state portability, there is little reason for young people to invest in lifelong, portable health insurance. Mandated coverage, pressure against full risk rating, and a dysfunctional cash market did the rest.

Youth, Age, and Entrepreneurship

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Edward Lazear writes,

we found that young societies tend to generate more new businesses than older societies. Young people are more energetic and have many innovative ideas. But starting a successful business requires more than ideas. Business acumen is essential to the entrepreneur. Previous positions of responsibility in companies provide the skills needed to successfully start businesses, and young workers often do not hold those positions in aging societies, where managerial slots are clogged with older workers.

Pointer from Mark Thoma. Another interesting quote from Lazear:

The importance of youth is illustrated by the stark contrast between two neighboring countries, Japan and Korea. Using the GEM survey data, we found that Japan’s rate of entrepreneurship (the proportion of individuals who own a business that they founded in the past 42 months) is just 1.5%. In Korea the rate is a much higher, 8%. The median age in Japan is 43; in Korea it is 34. The U.S., with an entrepreneurship rate of 4.4% and a median age of 36, is in the middle of the pack on both entrepreneurship rates and median age.

Phillips Curve Specifications and the Microfoundations Debate

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Scott Sumner writes,

As you may know I view inflation as an almost worthless concept… In contrast Krugman discusses the original version of the Phillips curve…which used wage inflation instead of price inflation. Whereas price inflation is a useless concept, wage inflation is a highly useful concept.

Fine. But Krugman also draws attention to how the level of the unemployment rate affects the level of the wage inflation rate. This takes us back to the original, pre-1970 Phillips Curve, from Act I in my terminology (Act I was the Forgotten Moderation, from 1960-1969, Act II was the Great Stagflation, from 1970-1985. Act III was the Great Moderation, from 1986-2007, and Act IV is whatever you want to call what we are in now.) The Act I Phillips Curve says flat-out that (wage) inflation will be high when unemployment is low, and vice-versa.

The Phillips Curve was revised in Act II, when the specification became that the rate of wage inflation increases when the unemployment rate is above below the NAIRU and decreases when it is belowabove the NAIRU. In other words, it relates the change in the rate of wage inflation to the unemployment rate. At the time, cognoscenti were saying that Friedman had moved the Phillips Curve one derivative.

Some comments.

1. The Act I Phillips Curve works better over the 27-year period (Acts III and IV) that Krugman covers. Within the sample period, in 9 out of the 10 years when unemployment is near the bottom of its range (less than 5 percent), wage inflation is near the top of its range (3.5 percent or higher). In all three high-unemployment years, wage inflation is less than 2.5 percent.

2. Although the rate-of-change in wage inflation is also correlated with the unemployment rate, the relationship is not as impressive. In the late 1990s, we had the lowest unemployment rate, but wage inflation actually declined (admittedly by only a small amount). More troubling is the fact that the very high rate of unemployment in recent years produced a decline in wage inflation hardly larger than that of the much milder previous recessions.

3. The overall variation in wage inflation over the 27 years is remarkably low. It ranges from 1.5 percent to 4 percent. When there is this little variation to explain, the actual magnitude of the effect of variations in unemployment on inflation is going to be pretty small. See the post by Menzie Chinn. If you do not have any data points that include high inflation, then you cannot use the Phillips Curve to explain high inflation. Chinn argues that the relationship is nonlinear. I would say that we do not know that there exists a nonlinear relationship. What we know is that we observe a relationship that, if linear, has a shallow slope. The most we can say is that if there is a steep slope somewhere, then there is a nonlinear relationship.

4. If you had given a macroeconomist only the information that wage inflation varied between 1.5 percent and 4 percent, that macroeconomist would never have believed that such a time period included the worst unemployment performance since the Great Depression. In terms of wage inflation, the last five years look like a continuation of the Great Moderation.

Some larger points concerning market monetarism, paleo-Keynesianism, and the microfoundations debate:

5. Concerning Scott’s view of things, I have said this before: Arithmetically, nominal GDP growth equals real GDP growth plus growth in unit labor costs plus the change in the price markup. If you keep the price markup constant and hold productivity growth constant, then nominal GDP growth equals real GDP growth plus wage growth. So it is nearly an arithmetic certainty that when nominal GDP grows more slowly than wages, then real GDP declines. But to me, this says nothing about a causal relationship. You could just as easily say that a decline in real GDP causes nominal GDP to grow more slowly than wages. What you have are three endogenous variables.

Scott insists on treating nominal GDP growth as the exogenous variable controlled by the central bank. To me, that is too much of a stretch. I am not even sure that the central bank can control any of the important interest rates in the economy, much less the growth rate of nominal GDP. Yes, if they print gobs and gobs of money, then inflation will be high and variable, and so will nominal GDP growth. But otherwise, I am skeptical.

6. I view paleo-Keynesianism as being hostile to Act III macro. I share this hostility. However, right now, you have saltwater economists saying, “Freshwater economists reduce macroeconomics to a single representative agent with flexible prices solving stochastic calculus problems. Hah-hah. That is really STOOpid.”

The way I look at it, the Act III New Keynesians reduced macroeconomics to a single representative agent with sticky prices solving stochastic calculus problems. They should not be so proud of themselves.

Paul Krugman calls Act III macro a wrong turn. (Pointer from Mark Thoma.) I would not be so kind. I also would not be as kind as he is to the MIT macroeconomists who emerged in that era.

You cannot just blame Lucas and Prescott for turning macro into a useless exercise in mathematical…er…self-abuse. You have to blame Fischer and Blanchard, too. Personally, I blame them even more.

Having said all that, I do not share Krugman’s paleo-Keynesianism. Just because the Lucas critique was overblown does not mean that other critiques are not valid. I have developed other doubts about the Act I model, and these lead me to believe that PSST is at least as plausible a starting point for thinking about macro.

Hal Varian on Big Data

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The self-recommending paper is here.

When confronted with a prediction problem of this sort an economist would think immediately of a linear or logistic regression. However, there may be better choices, particularly if a lot of data is available. These include nonlinear methods such as 1) neural nets, 2) support vector machines, 3) classifi cation and regression trees, 4) random forests, and 5) penalized regression such as lasso, lars, and elastic nets.

In one of his examples, he redoes the Boston Fed study that showed that race was a factor in mortgage declines, and using the classification tree method he finds that a tree that omits race as a variable fits the data just as well as a tree that includes race, which implies that race was not an important factor.

Thanks to Mark Thoma for the pointer.

Cognitive Capture

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Acemoglu and Robinson write,

the excess returns of connected firms may be a reflection of the perception of the market (and likely a correct perception) that during turbulent times there will be both heightened policy discretion and even more of the natural tendency of government officials and politicians to rely on the advice of a small network of confidants. For Timothy Geithner this meant relying on, and appointing to powerful positions, financial executives from the firms he was connected to and felt comfortable with. But then, there is no guarantee that these people would not give advice favoring their firms, knowingly or perhaps subconsciously (for example, they may be under the grips of a worldview that increases the perceived importance of their firm’s survival for the health of the US economy).

This refers to an “event study” that looks at how the prices of different financial firms responded to the announcement that Timothy Geithner would be Treasury Secretary. Pointer from Mark Thoma.

I tend to discount event studies. For one thing, I suspect that there is a lot of “survivor bias” in that event studies that fail to lead to results that show something the authors want to show probably never see the light of day. But I happen to agree with the hypothesis that financial regulators are subject to cognitive capture by the large financial firms.

Dean Baker on Housing Finance Policy

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He writes,

Way back in the last decade we had a huge housing bubble which was propelled in large part by junk loans that were packaged into mortgage backed securities (MBS) by Wall Street investment banks and sold all around the world. Unfortunately few people in policy positions are old enough to remember back to the this era, which is why they are now in the process of altering rules so that investment banks will be able to put almost any loan into a MBS without retaining a stake.

Pointer from Mark Thoma.

I have argued that the general trend of housing policy is to give Wall Street and the housing lobby, particularly the Mortgage Bankers Association, exactly what they want. Baker is one of the few economists on the left who is willing to speak up on this. When I suggested to an audience of conservatives that we needed to engage Brookings and the Urban Institute to study the effects of housing finance subsidies, people came up to me afterwards to say that they thought that those think tanks would not want to offend important donors.