In a comment on this post, Mark Thoma pointed out that Janet Yellen’s views have changed since 2005. In this piece from 2009, she says

the hand we have been dealt today doesn’t look anything like the textbook ideal that I just described. Instead, we are experiencing pervasive financial market failures with devastating macroeconomic effects. The normal monetary transmission mechanism has been hobbled by dysfunctional money and credit markets. Risk spreads have ballooned on supposedly safe assets like agency debt and mortgage-backed securities (MBS). What does optimal monetary policy look like in this situation? How do we gauge the effectiveness of policy actions, and how can we implement and communicate systematic policy responses under these conditions?

What strikes me is that Yellen’s views in 2005, that I cited in the earlier post, closely reflected the consensus point of view at that time. And the 2009 speech closely reflects the consensus view at that time.

Today, the problem for the 2009 consensus view is that financial markets recovered really well by the Spring of 2009, but the labor market, particularly as measured by the civilian employment/population ratio, has failed to recover. So now, macroeconomists are struggling to explain how a financial crisis five years ago could still be causing high unemployment today. (Of course, Reinhardt and Rogoff warned that the recovery would be slow, but other economists have challenged their view that financial crises produce slow recoveries.) Do we think that the new consensus will be “secular stagnation” and that Janet Yellen will once again join it?

He writes,

The New Keynesian model was built to explain a world of moderate fluctuations in GDP. It features temporary price rigidities, and the macroeconomic aggregates in the model are consistent with the optimizing behavior of individual consumers and producers. For certain types of questions – how should policymakers behave to stabilize an economy with mild fluctuations induced by price rigidities – it is the best model to use. Hence it’s popularity during the “Great Moderation” from 1984-2007 when there were no large shocks to the economy…

The IS-LM model, on the other hand, was built in the aftermath of the Great Depression to examine precisely the kinds of questions we faced throughout the Great Recession, issues such as a liquidity trap, the paradox of thrift, and how policymakers should react in such an environment. Why is it surprising that a model built to explain a particular set of questions does better than a model built to explain other things?

Read the whole essay. My guess is that even those who are inclined to be sympathetic to Thoma on this point, myself included, will have a hard time accepting the idea that one should switch models depending on circumstances. Yet I would argue that the evidence is that economists have done exactly that over the past 50 years.

Two pointers from Mark Thoma.

1. Simon Wren-Lewis writes,

An alternative and I now think better, vision would give more emphasis to how economics developed. Economic history would play a central role. Economic theory would be seen as responding to historical events and processes. For example placing Keynesian theory in the context of the Great Depression is clearly useful, given the events of the last five years. I think it is also important to recognise the links between economic theory and ideology. This is partly to understand why governments might not act on the wisdom of economists, but it also leads naturally to recognising that economists need to adapt to the social and political context in which they work. We should also be more honest that our wisdom might be influenced by ideology. Given the limits to experimental and econometric evidence, but with a very clear axiomatic structure, methodology is always going to be an important issue in economics.

Which reminds me, I need to recover the momentum on the book I am writing.

2. Miles Kimball and Noah Smith write,

Patrick Kehoe, one of the economists dismissed from the Fed, is a key figure in a school of economics called “Freshwater Macroeconomics” (the other, Ellen McGrattan, is his frequent co-author). The labels “Freshwater” and “Saltwater” go back to the arguments and new ideas generated by the double-digit inflation in the 1970s.

I wrote about this conflict over a decade ago. Back then, I considered myself on the freshwater side. Now I am more “a pox on both your houses.”

Kimball and Smith describe the appeal of each school of thought. My book will attempt to do that, also. But I also will explain why I came to reject both schools and instead turn to PSST.

He writes,

Keynesians like to say that there is a savings glut (an excess of saving over investment). They try to remedy it by spurring consumption. This is a mistake. There is an investment shortfall, because the financial, regulatory, and policy barriers to high-return investments have not been addressed. America urgently needs investments in modernized infrastructure, advanced science and technology, and job skills appropriate for the 21st century. We are sitting on top of an information revolution and nanotechnology revolution that could positively reshape healthcare, education, transportation, low-carbon energy systems, green buildings, water conservation, and environmental safety.

Pointer from Mark Thoma. Sachs and I would probably disagree about the proportion of the solution that consists of government leading vs. getting out of the way. However, his diagnosis seems to me to make some sense, unlike the savings glut story.

Thanks to Mark Thoma, I came across a recent IMF Conference honoring Stanley Fischer, who I have called the Genghis Khan of macroeconomics.

If I were you, I would jump to the last video, on policy responses to the crisis. The panel features Ben Bernanke (who wrote his dissertation under Fischer), Fischer, Ken Rogoff (who wrote his dissertation under Dornbusch, but perhaps had Fischer on his committee), and Larry Summers, who went to grad school at Harvard but who spent a lot of time auditing courses at MIT, including Fischer’s monetary economics course, which Summers remembers as being called 14.462 in the MIT catalogue. The panel is chaired by Olivier Blanchard, long-time protege of Fischer, and the first question during the Q&A comes from Jeffrey Frankel, another Dornbusch student. I didn’t find Bernanke or Fischer so interesting, so I would recommend fast-forwarding to minute 33, when Rogoff is speaking.

Rogoff eventually says that one source of financial crisis is ordinary debt. One of the reasons that debt is over-utilized is that it often comes with a government guarantee, either explicit or implicit. One solution he proposes is to get rid of bank deposits. Instead, he would have the Fed run ATMs, and the only transaction accounts people would have would be deposits at the Fed, which I’m guessing would not earn interest. In order to earn interest, people would have to invest in risky securities.. (Rogoff was racing through his talk at this point, so I am doing some interpolation here that might not be exactly correct.)

36 years ago, these were my homies. Rogoff makes some amusing remarks about the macro wars of that time, and I think he correctly pinpoints Fischer and John Taylor as two economists who “bridged” the freshwater and saltwater schools. Later, Summers mocks Minnesota, just as in the old days.

Summers gives the most provocative talk, and it becomes the focus of much of the subsequent discussion. He asks why it was that for the decade prior to the financial crisis we needed the wealth illusions of bubbles in order to maintain an economy even close to full employment. He argues that the full-employment, non-bubble real interest rate must have been below zero for a long time, and that it may remain zero for a long time.

In response to Frankel’s question, Summers says that this situation can be attributed in part to Moore’s Law. Computers as a form of capital are characterized by decreasing prices, and this created a state of chronic excess supply in capital markets. The “savings glut” came not just from foreign sources but from the fact that the cost of obtaining capital in the form of computing equipment kept falling, making investment demand too low to absorb savings.

He is talking about a Great Stagnation not of supply but of demand. As he points out at the start of his talk, nobody has suggested anything like it since the 1940s, with the “secular stagnation” hypothesis. (I think that one of the proponents of that hypothesis was Summers’ uncle, Paul Samuelson, but I may be wrong about that.)

If you start by thinking in terms of classical economics, there are so many problems with Summers’ story that one does not even know where to begin. However, among Fischer’s horde, he is taken seriously. Bernanke does push back, invoking Bohm-Bawerk, as taught to us by Samuelson, to point out the extreme and implausible implications of a negative interest rate.

The panel tends to reinforce my complaints about the homogeneity of professional thinking, which is due, in my view, to Fischer’s over-breeding. These are macroeconomists who became prominent in the 1980s and 1990s. How is it that they constitute the panel here? The equivalent would be watching a panel in 1980 that consisted entirely of economists from the generation that thought wage-price controls were the best tool for fighting inflation.

David Altig writes,

why should there be a “wealth effect” at all? If the price of my house falls and I suffer a capital loss, I do in fact feel less wealthy. But all potential buyers of my house just gained the opportunity to obtain my house at a lower price. For them, the implied wealth gain is the same as my loss. If buyers and sellers essentially behave the same way, why should there be a large impact on consumption?

This was the crux of his blog post, although he later crossed it out because a colleague suggested it was oversimplified. Pointer from Mark Thoma.

Some comments:

1. When land prices rise, we are looking for asymmetries between the behavior of the winners from higher land prices (home owners) and the losers from higher land prices (non-owners). Conversely, when land prices fall, the winners are non-owners and the losers are owners. If the winners and losers behave symmetrically, then the effect on overall consumption should not be large.

2. As Altig points out, it could be that access to credit behaves asymmetrically. Owners experience large swings in access to credit to finance consumption via home-equity extractions, while non-owners do not experience such swings.

3. There may be a Shillerian channel, based on expectations of house price changes. That is, the effect of past changes in house prices is symmetric. However, as prices rise, owners tend to be people with high expectations for future price increases. They expect their wealth to rise, and they spend some of these anticipated gains. If non-owners had similar expectations of rising land prices and were symmetrically concerned about future increases in their living costs as a result, then they would save more. But they are not symmetrically concerned.

4. If we get out of the AS-AD framework and into the PSST framework, a broad-based land-price bubble might be less distorting than an uneven land-price bubble. A broad-based bubble creates too many real estate agents, mortgage loan officers, and homebuilders. An uneven bubble causes all sorts of ancillary businesses to locate differently. Entrepreneurs open restaurants and high-end shopping centers in booming areas*, and then when the bubble bursts they are stuck with bad investments.

*But why are they not closing such businesses in lagging areas?

Simon Wren-Lewis writes,

My second complaint is that the microfoundations used by macroeconomists is so out of date. Behavioural economics just does not get a look in. A good and very important example comes from the reluctance of firms to cut nominal wages. There is overwhelming empirical evidence for this phenomenon (see for example here (HT Timothy Taylor) or the work of Jennifer Smith at Warwick). The behavioural reasons for this are explored in detail in this book by Truman Bewley, which Bryan Caplan discusses here. Both money illusion and the importance of workforce morale are now well accepted ideas in behavioural economics.

Read his whole post. The paragraph I quoted includes links that I did not transfer here. Pointer from Mark Thoma.

Some comments:

1. Just because something can be shown to exist at the micro level does not mean that it is important at the macro level. (This is in some ways equivalent to the point that just because you have what you think makes a neat microfoundation does not mean that it helps you with macro.)

2. In particular, if worker A at firm X suffers from money illusion, that does not imply that macroeconomic behavior will look like that worker and firm. There is plenty of exit and entry among firms as well as turnover in the labor force.

3. Indeed, I happen to agree with Robert Solow that what makes the DSGE framework so unpromising is that it typically insists on modeling a single consumer/worker/capitalist as representative of the entire economy. Obviously, you tend to forget about entry and exit and labor force turnover when you do that.

4. When one looks at macroeconomic data for evidence of money illusion, the results seem to me to be decidedly mixed.

a. Matt Rognlie writes,

A large output gap is extraordinarily effective at bringing inflation down from, say, 8% to 2%, but far less effective at bringing about a drop from 2% to -2%.

If that is true, then it looks like a point in favor of money illusion. To believe that it is true, you have to believe in the original Phillips Curve. That’s easy to do if your macroeconomic thinking was shaped by the 1960’s. Maybe it’s easy to do if your thinking was shaped by the last five years, although in that case you have only observed one region of the Phillips Curve. Looking at other time periods raises doubts.

b. If you put your chips on nominal wage stickiness to explain recessions, then I do not see how you avoid predicting a countercyclical share of labor income in GDP. That prediction is strongly violated by a number of downturns, including the current one.

c. Also, if you put your chips on nominal wage stickiness, youth unemployment should be relatively low in a recession. People who are just entering the job market are not comparing current job offers to previous salaries.

d. If there is money illusion, probably there are other illusions that allow employers to adjust at the margin without being able to reduce wages. As an employer, I can put more work on your desk. I can reduce bonus payouts. I can require a longer vesting period for stock options or pension benefits. I can reduce the match on your 401(K). I can increase what you have to contribute to health insurance. There seem to be enough margins available that sticky nominal wages should not matter.

5. On balance, I think that the case for wage stickiness as a crucial macroeconomic phenomenon is quite flimsy, notwithstanding the strong case for nominal wage stickiness that can be made by looking at micro behavior.