Category Archives: PSST and Macro

The Elastic Economy and the Great Moderation

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Alex Tabarrok writes,

Since the great recession ended, growth in real GDP has been much less volatile than in the 1950s to 1980s. Indeed, volatility has been lower even taking into account the great recession.

He goes on to point out problems with many theories that try to explain the continued Great Moderation.

I offered my explanation in 2003, in an essay called The Elastic Economy.

The United States economy has become more diverse and more robust. We are better able to withstand shocks, minimize concentration of economic power, and sustain growth without being hampered by resource constraints. This can be summarized by saying that the economy has become more elastic.

…There are several factors that have caused the economy to become more elastic. They include product diversity, globalization, the Internet, and increased innovation.

There are now more patterns of specialization and trade. That reduces the overall economic significance of any one product. That means that any particular shock causes less overall pain than it would have fifty years ago.

If this view is correct, then we should be less enthusiastic about claiming that policies in 2008-2009 prevented another Great Depression. Because we have a more elastic economy than we did in 1930, a repeat of the Great Depression was never going to happen.

The elastic-economy hypothesis fits in among theories of structural change to explain lower volatility in GDP growth. Alex points out that such theories, including the theory that sectors like health care are less volatile than manufacturing, want to predict further reductions in volatility in recent years, and this has not happened. Perhaps that is because asset markets have become a more important source of volatility than they were 30 years ago.

Corporate tax cuts, math, and intellectual swindles

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John Cochrane writes,

Each dollar (per worker) of static tax losses raises wages by [more than one dollar] It’s always greater than one… A number greater than one does not mean you’re a moron, incapable of addition, a stooge of the corporate class, etc.

This is also a lovely little example for people who decry math in economics. At a verbal level, who knows? It seems plausible that a $1 tax cut could never raise wages by more than $1. Your head swims. A few lines of algebra later, and the argument is clear. You could never do this verbally.

For the other side of the controversy, see Mark Thoma.

Let me swindle you with the following example.

1. We have the GDP factory, with two workers, A and B.

2. Each worker faces a different tax rate on wages.

3. The pre-tax wage of worker A is fixed. It cannot change.

4. (a) Each worker stays fully employed. (b) That means that the ratio of the marginal product of worker A to the marginal product of worker B must remain constant.* (c) That means that the ratio of the after-tax wage of worker A to the after-tax wage of worker B must remain constant.

*That ratio is completely determined by the production function, which is given, and by the quantities used of the two workers, which are fixed at full employment.

OK, now we cut the tax rate for worker A. What happens to the pre-tax wage of worker B?

At the fixed pre-tax wage of worker A, the after-tax wage for worker A goes up. Because of 4(c), that means that the after-tax wage of worker B must go up. The only way that can happen is if the pre-tax wage of worker B goes up. And to get worker B’s after-tax wage to go up by, say $1, you have to raise worker B’s pre-tax wage by more than $1. So worker B gets a big raise.

Substitute “capital” for worker A, “the interest rate” for worker A’s wage, and the corporate income tax for worker A’s tax rate, and I think you have the story that everyone is talking about.

But this is a swindle. We have fixed both the quantity and price of worker A. Taking worker A to be capital, the fixed supply is plausible because you think “how can we instantly adjust the supply of capital?” The wage, er, interest rate is fixed because, well, we know that the world interest rate is given, right?

But it cannot be right. A fixed wage suggests a perfectly elastic supply. A fixed quantity suggests a perfectly inelastic supply. There is a contradiction between 3 and 4(a).

The larger issue is that the simple model of a GDP factory with two factors of production and full employment is just silly. And even though other models add enough complexity to require computers to solve, they are also just silly.

There are many types of capital, which is what creates all of the lobbying and infighting over corporate taxes to begin with. There are also many types of labor, which substitute for and complement with the various types of capital in different ways. Adjustment takes time, and not all types of capital and labor are continuously employed. Over time, there is innovation, some of which is exogenous and some of which is in response to the tax change. The supply of each type of capital and each type of labor is neither perfectly elastic nor perfectly inelastic (and certainly not both!).

The moral of the story, in my view, is that forecasting the impact of economic policy is not a science. We know that, but then people demand a forecast, and they turn to a CBO “score” as if it were the final word on the subject. I have a forthcoming essay on the mis-use of CBO scores.

Macroeconomics as narrative

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Challenging the narrative that the Fed’s quantitative easing was a success, Brian S. Wesbury and Robert Stein write,

The Fed boosted bank reserves, but the banks never lent out and multiplied it like they had in previous decades. In fact, the M2 money supply (bank deposits) grew at roughly 6% since 2008, which is the same rate it grew in the second half of the 1990s.

So, why did stock prices rise and unemployment fall? Our answer: Once changes to mark-to-market accounting brought the Panic of 2008 to an end, which was five months after QE started, entrepreneurial activity accelerated. New technology (fracking, the cloud, Smartphones, Apps, the Genome, and 3-D printing) boosted efficiency and productivity in the private sector. In fact, if we look back we are astounded by the new technologies that have come of age in just the past decade. These new technologies boosted corporate profits and stock prices and, yes, the economy grew too.

The one thing that did change from the 1990s was the size of the government. Tax rates, regulation and redistribution all went up significantly. This weighed on the economy and real GDP growth never got back to 3.5% to 4%.

Pointer from John Mauldin. My thoughts:

1. Recall that Ed Leamer’s macro book is called “Macroeconomic patterns and stories.”

2. We should certainly be skeptical of the narrative that the Fed achieved something. After all, they simply re-arranged the maturity structure of government debt, which is something that the Treasury can do (or un-do). As I keep saying, the Fed is just another bank, playing the maturity mis-match game. So in theory their actions should have little effect. In practice, they did not hit their inflation target. So the only thing the standard narrative has going for it is that it pleases people who like to see the Fed as important and successful.

3. We should be skeptical of Wesbury’s and Stein’s narrative, also.

Renewable != Sustainable

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Benjamin Zycher writes,

there is nothing “clean” about renewables. There is the heavy-metal pollution created by the production process for wind turbines, along with their noise and flicker effects. There is the large problem of solar panel waste. There is the wildlife destruction caused by the production of renewable power. There is the land use both massive and unsightly, made necessary by the unconcentrated nature of renewable energy.

And above all: There is the increase — yes, increase — in the emissions of conventional effluents caused by the up-and-down cycling of the conventional backup generation units needed to avoid blackouts caused by the unreliability of wind and solar power.

(links omitted)

In Specialization and Trade, I make the point that sustainability is best measured by profitability at market prices. The attempt by environmentalists to second-guess prices is misguided. Recycling, if measured at market prices, is not sustainable. The use of renewable resources for energy, if assessed at market prices, is not sustainable. It is likely that from a strictly environmental point of view, practices like buying local and subsidizing renewable energy have adverse effects.

Is the economy illegible?

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In the model of the economy as a GDP factory, the most fundamental equation is the production function, Y = f(K,L).

This says that total output (Y) is determined by the total amount of capital (K) and the total amount of labor (L).

Let me stipulate that the economy is legible to the extent that this model can be applied usefully to explain economic developments. I want to point out that the economy, while never as legible as economists might have thought, is rapidly becoming less legible.

For example, the analysis of changes in the trend in productivity requires extremely fine legibility. You start with the measure of Y/L, which is problematic, because you have to add together disparate goods and services to get Y. You have to aggregate all sorts of different specialized workers to get L. Next, to get a trend in productivity, you have to compare Y/L between two periods relatively far apart, say 1986 and 2016. The difference between what you are aggregating then and now is staggering.

Once you look at differences across decades, adjusting for price changes becomes important but impossible. For example, Bret Swanson says that the computing power in his iPhone would have cost $12 million in 1991. If for the purpose of comparing Y/L today to Y/L in 1991 you valued every iPhone at $12 million, you would report an enormous increase in real GDP and hence in productivity.

Finally, to get the change in the productivity trend, you have to attach meaning to the difference of the difference, e.g., the difference between the change in Y/L from 1986 to 2001 and the change in Y/L from 2001 to 2016. That is asking the data to be correct to an additional decimal point.

Here are some other indicators of the decline in legibility:

1. The increasing disconnect between stock prices and earnings. I have made the point about Amazon. In fact, Amazon typifies the decreasing legibility of corporations. Commenters who gave me pushback on Amazon said that they do not think it will end up primarily as a retailer. To me, all the top tech companies have vague business models, particularly if you look ahead several years, and particularly if you compare them with the old industrial giants. Bethlehem made steel. GM made cars. What does FaceGoogle make? Space for ads? Do you think that will still be their primary business five years from now? If so, do you like their prospects? Folks like Ben Thompson seem to think that the business models of all the major tech companies necessarily must evolve radically, which to me makes their future earnings harder to predict.

2. The increasing disconnect between corporate earnings growth and GDP growth. Some of this is due to the fact that a lot of important U.S. corporations are multinationals, so that their earnings are not just a function of what goes on in the U.S. [corrected]

3. The increasing disparities in individual earnings. I bet if you looked at the ratio of the pay of a college president to that of a cafeteria worker today and compared it to that ratio in 1980, it would blow your mind.

4. The increasing disparities in cost of living. I bet if you looked at the ratio of the cost of living in San Francisco to the cost of living in Peoria and compared it to that ratio in 1980, it would blow your mind.

5. Increasing disparities in tastes. The usefulness of a single price index, such as the Consumer Price Index or the GDP deflator, to describe inflation depends on the validity of the assumption of a representative consumer. I don’t see that today. One family shops for groceries at Walmart, and another shops at Whole Foods. One household puts discretionary income into private school for the children, and another puts it into home entertainment.

Still, economists want to treat the economy as if it were legible.

–They tell you that we are in a productivity slump, and we need to explain it and figure out how to solve it. I think that the numbers are not reliable enough to say.

–They tell you that inflation is below target, and central banks are puzzled about how to respond. I think that we see such large changes in relative prices that the very concept of “overall inflation” loses meaning and monetary policy becomes irrelevant until the central banks get into an orgy of money-printing.

–They tell you that “the” real interest rate is low, but what happens if you take health care and education out of the inflation numbers? I mean, if as an entrepreneur you could respond to the scarcity of schools and hospitals (as indicated by rising prices) by borrowing money to launch a new one, then that low real interest rate would mean something. But you can’t do that. Meanwhile, if you’re borrowing to finance a new firm in the solar power business, where prices are going down every year, maybe that interest rate does not look so low.

Money, interest, and the economy

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John Cochrane writes,

Investment responds to the stock market, and the stock market moves because risk premiums move, not because interest rates move.

He goes on to suggest that if monetary policy can effect the economy, it must work through the channel of affecting the risk premium. That seems dangerous. To me, it also seems far-fetched. I view this as helping to reinforce the Fischer Black/Arnold Kling ultra-heterodox view that central banks are not macroeconomically significant.

The theory that central banks are irrelevant can withstand the supposed counter-example of hyperinflation. We view hyperinflation as a fiscal phenomenon. The government cannot tax and borrow enough to match spending, so it pays its bills by printing (ultimately worthless) paper.

Cochrane links to an essay by Dan Thornton, in which Thornton argues that the evidence is weak that the interest rate affects spending.

“So why do policymakers believe that monetary policy works through the interest rate channel and that monetary policy is powerful?” Well, there was one important event that brought economists and policymakers to this conclusion. Specifically, the Fed under Chairman Paul Volcker brought an end to the Great Inflation of the 1970s and early 1980s.

Indeed, this is the great counter-example to my view the central banks are irrelevant. I have to argue that the Great Inflation and the Volcker Disinflation were not the monetary-policy phenomena that they are widely viewed as being.

My best alternative hypothesis concerning the Great Inflation is that the breakdown of the sort-of gold standard of Bretton Woods and the use of “incomes policies,” most notably the Nixon wage-price controls, caused a change in pricing norms away from stability and toward upward ratcheting. The actions of the oil cartel in the 1970s can be viewed as both a response to the breakdown of the Bretton Woods system and as a causal factor in itself that affected pricing norms throughout the economy.

My best alternative hypothesis concerning the Volcker disinflation is that it was not Volcker that produced the shift to a regime with less inflationary pricing norms. Perhaps deregulation, particularly in transportation, played a role. The collapse of the oil cartel, a collapse which decontrol of the U.S. oil market probably helped to foster, was a factor also.

Incidentally, I am not as convinced as Thornton that housing construction and consumer durables are insensitive to interest rates. Those sectors certainly are highly cyclical, with Ed Leamer showing that they are almost always implicated in recessions. For much of the post-war period, the institutional environment, including key financial regulations, ensured that any rise in long-term nominal interest rates caused credit for housing to dry up. But the regime of the 1960s, with strong restrictions against interstate banking and with deposit interest ceilings, was dismantled by 1990.

The new regime appeared to be nearly recession-proof until 2008. Then what happened? I think that we will be arguing forever about what exactly caused the recession to be so deep as well as what role, if any, monetary and fiscal policy played in the recovery.

Math and uncertainty

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A commenter writes,

if the math is done right, it should then say precisely that: there isn’t enough data to resolve the parameters you’re trying to impute with any reasonable degreee of confidence. The ‘anti-math’ people seem to forget that uncertainty is itself a quantifiable thing.

This does not address the problem that Richard Bookstaber and others call radical uncertainty. Consider what the CBO director wrote concerning the agency’s evaluation of the ARRA (the 2009 Stimulus bill).

The macroeconomic impacts of any economic stimulus program are very uncertain. Economic theories differ in their predictions about the effectiveness of stimulus. Furthermore, large fiscal stimulus is rarely attempted, so it is difficult to distinguish among alternative estimates of how large the macroeconomic effects would be. For those reasons, some economists remain skeptical that there will be any significant effects, while others expect very large ones.

Note that he did not attempt to quantify this uncertainty, nor could he have done so. Note also that what Congress and the public focused on were the apparently precise numerical estimates of the CBO model, rather than the uncertainty of those estimates.

The CBO uses a standard macro model, in which there is only one type of worker in the economy. I believe that workers in today’s economy are highly specialized, and that this accounts for the difficulty in creating new patterns of trade when old patterns become unprofitable. It is easier to use math to analyze a model with one type of worker than it is to apply math to my model. I think that is an argument against the tyranny of math in economics.

Elasticity of economic beliefs

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Bryan Caplan writes,

If you’re even mildly Keynesian, you know that downward nominal wage rigidity occasionally leads to lots of involuntary unemployment. If, like most Keynesians, you think that your view is backed by overwhelming empirical evidence, I have a challenge for you: Explain why market-driven downward nominal wage rigidity leads to unemployment without implying that a government-imposed minimum wage leads to unemployment. The challenge is tough because the whole point of the minimum wage is to intensify what Keynesians correctly see as the fundamental cause of unemployment: The failure of nominal wages to fall until the market clears.

Links omitted. Read the whole post. My thoughts:

1. In my long essay, which is worth re-reading, I write,

it is politically consistent for someone on the left to believe that a rise in the minimum wage would not reduce hiring and also that more immigration would not depress wages. Analytically, however, these are opposite views. The minimum-wage increase will not reduce hiring if one treats labor demand as highly inelastic (so that a small change in hiring will be associated with a given change in wages). Increased immigration will not depress wages if one treats labor demand as highly elastic (so that a large change in hiring will be associated with a given change in wages). I think we are already starting to see economists opt for political consistency at the expense of analytical consistency.

2. On the point about downward rigidity of nominal wages as essential for unemployment, that has long been controversial. The mainstream view, particularly in textbooks, is that downward wage rigidity is important. But often it is difficult in the data to find the movements in real wages that would one expect to be associated with fluctuations in employment. And some Keynesians (including Keynes himself) have claimed that rapid wage reductions in a time of high unemployment would not reduce unemployment.

I do not wish to revisit the Keynesian macro controversy here. My main point is that economists are willing to take analytically inconsistent positions in order to remain politically consistent. Bryan wants to call them on it, but I think that the trend is against him.

Scott Sumner’s macroeconomics: my thoughts

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He writes,

I’ll use “(e)” to denote a (market) expected value.

NGDP(e) is the single most important variable in macro; it should be the centerpiece of modern macro.

How can we work with a central concept that is purely mental? Nominal GDP, or NGDP without the (e), is a measure derived from the market exchange of goods and services. Most concepts in macroeconomics, such as interest rates, or prices, are observable when goods or securities change hands.

NGDP(e) is not an observable result of goods or securities changing hands. It is something in people’s heads.

But it’s even more problematic than that. At least 99.9 percent of all people do not even have an NGDP(e) in their heads. Even most economists do not have one.

Even if you had a futures market in NGDP, NGDP(e) would still be a purely mental concept. In the wheat market, if you sell 1000 bushels of wheat forward, on the day that the contract expires you could deliver 1000 bushels of wheat to fulfill the contract. (Actual delivery does not take place in such markets, because buyers and sellers unwind their positions at expiration.) But nobody can deliver NGDP against an NGDP futures contract. It is a pure bet.

In any event, an NGDP futures market currently does not exist. So the most important variable in macroeconomics is something that exists in people’s minds, and yet in truth it exists in almost no one’s mind. I worry that this is like saying that in physics the most important variable is the ether, even though no one can observe it.

Sumner writes,

Low and stable NGDP growth minimizes the welfare costs of “inflation”, and also leads to approximately optimal hours worked.

NGDP is an observable variable, and Sumner argues that low and stable NGDP growth is associated with good performance of inflation and employment. So why bother with NGDP(e) at all?

At the risk of putting words in Sumner’s mouth, I think he would say that NGDP(e) is important because the Fed affects NGDP by manipulating NGDP(e). How did he get there?

Monetary theorists used to say that the Fed manipulates NGDP by manipulating the quantity of money. The problem with this is that it is impossible to find a definition of money that can satisfy two conditions at the same time: (1) that the Fed can control it; and (2) it closely correlates with NGDP. The former requires a narrow definition of money, and the latter requires a broad definition.

Old Keynesians said that the Fed manipulates NGDP by manipulating the short-term interest rate. When the short-term rate gets stuck at zero, it has to manipulate the long-term rate. Or it becomes impotent. But even when it is not stuck at zero, the Fed’s manipulations often seem ineffective. For one thing, long-term interest rates sometime do not respond, or they respond perversely.

Then there are the New Keynesian types who say that the Fed manipulates NGDP by manipulating expected inflation. But to me that is another ethereal concept. At the risk of putting words in their mouths, the New Keynesians are saying that the Fed can mysteriously change expected inflation through “quantitative easing” even if short-term interest rates and long-term interest rates are both impervious to Fed actions, or even if long-term rates react perversely.

From the New Keynesian view, it is a relatively small step to Sumner’s view. Just swap out the ethereal expected inflation for the ethereal NGDP(e).

Got it? In modern macro, we have everybody working in the GDP factory. And we have everybody forming expectations about the price of the output from this GDP factory, or about the total nominal value of that output. And booms and recessions are caused by changes in these expectations. And the Fed can manipulate these expectations through an immaculate process that cannot be measured using interest rates or the money supply.

Oy.

I know that almost nobody who reads Specialization and Trade buys into my view that movements in aggregate price indices mostly reflect habits and inertia, rather than central bank operations. But when you see the contortions that monetary theorists have gone through over the years, I think I have a fair case.

Preach it, brother John

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John Cochrane writes,

there is a deep lesson in their style of modeling: Heterogeneity. Misallocation. Dispersion. Inequality. The key lesson is not that “regulation is killing US firms on average.” The US as a whole is doing badly because firms are in the wrong place — misallocation. Each individual firm may feel it’s doing fine. It might consider moving to San Francisco, but say “well, we might be more productive there, but wages are much higher because you have to pay people enough to buy a house, so we wouldn’t make any more money if we were there.” More to the point, a new business who would embody the higher productivity, get workers to move, and put the old unproductive business out of business can’t start.

Macroeconomics and our numbers are designed around the “representative firm” and the “representative worker.” But you are seeing here the macroeconomic effects of microeconomic distortion, and only visible in the amazingly large, widening and persistent differences in productivities, wages, and incomes across areas and companies.

Read the whole post. He discusses two recent papers on the cost of housing supply restrictions. These have gotten a lot of play on other blogs as well. But I emphasize the methodological point. It is very much pro-PSST.

Incidentally, one argument against building more housing that Noah Smith tries to answer is that building more high-quality housing in, say, San Francisco, would simply induce more people to move there. With this “induced demand,” so the argument goes, the cost of living there would not fall. Noah has one response, which is to ask whether the proponents of the argument would go so far as to suggest that destroying housing would lower prices. My alternative response is to say that if “induced demand” is true, then that makes the welfare benefits of more building all the greater.