Category Archives: PSST and Macro

Bank Lending and Non-bank Lending

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Daniel Nevins, in Economics for Independent Thinkers, a book I mentioned the other day, thinks of non-bank lending as coming from savings and bank lending as created by fiat. I do not think in those terms.

Think of an economy that includes fruit tree growers, households, and banks. The fruit trees represent risky, long-term investments.

The fruit tree growers finance their investment with a combination of debt and fruit-tree equity. Households may purchase some of the fruit tree debt directly. This would be called non-bank lending. Banks purchase the rest of the fruit-tree debt and fund it with a combination of bank equity and liquid deposits. The fruit tree debt that the banks fund is owned indirectly by households.

In the aggregate, households hold everything. Not every household is identical, but in the aggregate they hold the fruit tree equity, the direct fruit tree debt, and the indirect fruit tree debt that comes to the household in the form of bank equity and liquid deposits.

Now, fruit tree growers are households, just like anyone else. So you can think of an increase in bank lending as a bank creating a deposit at the household of a fruit tree grower in exchange for more debt issued by that fruit tree grower. That may be the way that Nevins wants to think of it,, and he thinks that this makes it much different from non-bank lending, because the bank can create a deposit seemingly out of thin air. He would say that it does so without prior saving, although he adheres to the identity between current saving and current investment.

In contrast, I think of bank lending and non-bank lending as doing the same thing, namely funding the debt issued by fruit tree growers. The only difference is that with non-bank lending, households have a direct ownership of the debt, while with bank lending their ownership is indirect.

Households may have a limited appetite for direct holding of fruit tree debt. And they may have a less limited appetite for holding that debt indirectly. In that case, if fruit tree growers and bank managers become more risk tolerant, you may get an expansion of fruit tree investment along with an increase in bank lending. Conversely, if fruit tree growers and bank managers become more risk averse, you may get a contraction.

The bottom line is that I think that bank credit matters, just as Nevins does. But I am not comfortable with his semantics.

Measuring Output of the GDP Factory

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Martin Feldstein writes,

More generally, as Triplett and Bosworth (2004) note, the official data imply that productivity in the health industry, as measured by the ratio of output to the number of employee hours involved in production, declined year after year between 1987 and 2001. They conclude (p. 265) that such a decline in true productivity is unlikely, but that officially measured productivity declines because “the traditional price index procedures for handling product and service improvements do not work for most medical improvements.” More recent data show that health sector productivity has continued to decline since 2001.

When you think of a factory producing, say, slate shingles, measurement of output is pretty straightforward. That makes measurement of productivity pretty straightforward.

Now introduce a second good, iron nails. These are produced in a different factory, but the idea of aggregation is to treat the economy as if it were a single GDP factory producing shingles plus nails. Of course, if you measure output as shingles plus nails, you will get strange results. If the economy produces 1 less shingle and 101 more nails, the total goes up by 100. But you do not know if the value of what was produced went up at all.

To obtain a more reasonable measure of total output, the statisticians take a weighted average of nail production and shingle production, where the weights are based on relative prices. If one shingle sells for $1.01 and one nail costs $.01, then producing 1 less shingle and 101 more nails results in no change to total output.

But using relative prices this does not completely solve the problem. Relative prices can change. Then you have to decide whether to base the weights on last year’s prices, this year’s prices, or some combination of the two.

But choosing a relative-price base year does not completely solve the problem, either. Relative prices can change because of quality change. Suppose that this year the shingle maker produces shingles that are more durable than the shingles produced last year, but charges the same price. Because quality has gone up, the relative price has gone down. Will the statisticians capture this?

Think of what you are trying to accomplish with these sorts of measurements. You might start by asking for any particular product how many hours a low-skilled worker would have to work in order to obtain that product. Brad DeLong once calculated that five hundred years ago it would take someone about three days in order to obtain the equivalent of one bag of flour. For today’s low-skilled workers in the U.S., this would take only a matter of minutes.

But then, how do you take a weighted average over many products? What do you do about quality change? How do you value new products?

Next, you have to note that people with more skills have higher wages, which reduces the number of hours that they must work to obtain the same goods. As the skill mix of the population changes, how do we want that to affect our measure of the productivity of the GDP factory?

In my view, the attempt to treat the economy as a GDP factory is bound to be very far from precise. It always amazes me when economists take seriously a concept like “the change in the trend rate of productivity.” The level of productivity is a very imprecise measure, for the reasons sketched above. When you measure the growth rate of productivity, you necessarily boost the noise to signal ratio. Then, when you measure the change in the rate of productivity growth rate of productivity, you once again boost that noise to signal ratio, to the point where you are pretty close to talking nonsense.

Climate Science vs. Macroeconomics

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Climate change is much in the news. My view of climate science is that it shares a lot of the same problems as orthodox macroeconomics. Common features include:

1. Use of computer models in which there are a variety of parameter choices that can be used to fit historical data. There is no single model that is thought to represent truth. Instead, forecasts are made using a “consensus” of several models.

2. High causal density.

3. Some question about the use of aggregate data. Macro talks about “the” wage rate or “the” capital stock or “the” unemployment rate or “the” price level, but the divergencies and disparities are much more significant. Similarly, climate science talks about “the” average global temperature, when variations across seasons and locations is enormous.

Some differences include:

1. Macroeconomics clearly has some intrinsic political survival value. The Fed wants to be as powerful as it can be, so it sponsors a lot of research that deals with the importance of monetary policy. Politicians want excuses to run deficits, so Keynesian macro is attractive to them. Climate science has less intrinsic political value. Politicians do not really want to undertake the policies that would be needed to reduce carbon dioxide emissions.

2. Keynesian macroeconomics notoriously contradicts what one would predict using microeconomic models that otherwise work well. Climate science has more reliable “microfoundations” in greenhouse gas theory, although the fact that carbon dioxide is a relatively minor greenhouse gas (compared with water vapor, for example) is rarely mentioned in the press.

3. The proponents of Keynesian economics, while they might seem a bit dogmatic to someone like me, are not out to suppress those who disagree. The vast majority of them are charitable enough to acknowledge that there are reasonable doubts about the subject. Of all macroeconomists, I can think of only one who regularly hurls snarling, ad hominem insults at those who disagree. The others stick to arguing substance. Proponents of climate change theory routinely derogate skeptics.

I am a macroeconomics skeptic. I think that my background in the subject is deep enough that my reasons for skepticism are legitimate. See, for example, my memoirs of a would-be macroeconomist.

I am a climate science skeptic, but not based on a similarly deep background. I just look at the superficial similarities with macroeconomics and infer that skepticism is warranted. It is plausible to me that the climate “consensus” is way off. However, it could be off in either direction–maybe the temperature increase will be faster and sharper than the consensus forecast.

When it comes to the differences between macro and climate science, points (1) and (2) favor climate science. However, point (3) leans against climate science. Good ideas are persuasive. If you need to excommunicate unbelievers, you are dealing in religion, not science.

Seaweeding

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Seasteading is a new book by Joe Quirk, with Patri Friedman. I cannot resist calling it quirky. If you are expecting the book to consist mostly of wacko libertarian ideas, you are wrong. It consists mostly of wacko environmentalist ideas. Apparently, there exist visionaries or crackpots, or both, who think that seaweed and other ocean life can provide cheap food, cheap energy, and cheap carbon sequestration. Here are some random excerpts:

Ricardo has shown that his most basic sea farm costs only $200.00 US to construct, covers only a half hectare in size, and supports five people with year-round harvests of diverse crops. (p. 85)

an ultrahealthy algae species called dulse. . .smoking it as if it were meat they were astonished to find it tasted like [bacon] (p. 98)

The authors suggest that adding iron to the Southern Ocean circling Antarctica alone could reduce carbon dioxide levels by 15 percent. (p. 146)

the ocean’s stored energy can be tapped by OTEC, or ocean thermal energy conversion. . .OTEC produces no greenhouse gases, blights no land, is not visible from shore, requires minimal maintenance, and runs twenty-four hours a day, 365 days a year. p. 146-148

If you take away any message from this book, it is this: Seasteading is about emigrant rights.
p. 301

1. I am skeptical that there are these twenty-dollar bills lying on the sidewalk floating in the oceans.

2. Even if there are twenty-dollar bills floating out there, it is not clear to me that you need to live on the ocean in order to collect them.

3. Do not mistake resources for wealth. Wealth consists of patterns of sustainable specialization and trade. There is plenty of land in the U.S. Land is only scarce in places like New York or San Francisco, where the patterns of specialization and trade are so lucrative.

4. From a PSST perspective, the most promising economic model for a seastead would be as a seaport. Find a part of the coast that lacks a natural harbor, set up a seastead harbor, and build a bridge or tunnel to connect the seastead to the land. That would create new opportunities for specialization and trade.

Best Book of the Year?

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Kevin Laland’s Darwin’s Unfinished Symphony is sure to make my top five and the early favorite to make number one. It got a mention from Tyler Cowen and a brief review from Robin Hanson. I would be curious to know what Jason Collins thinks of it. Laland is a person I would very much like to spend a few hours with batting ideas around.

Laland’s field is evolutionary neuroscience, or so I would guess. The book is focused on the co-evolution of brain capabilities and culture in humans. A central question is how culture came to be so advanced in humans relative to animals. To address that, one must try to understand how culture is developed, transmitted, and retained.

On page 7, Laland offers his definition of culture as

the extensive accumulation of shared, learned knowledge, and iterative improvements in technology over time.

Recall that my working definition of culture is “socially communicated thought patterns and behavioral tendencies.”

Late in the book, Laland uses dance as an example of culture.

The social structure of many communities. . .gain much of their cohesion from the group activity of dancing. Historically, dance has been a strong, binding influence on community life, a means of expressing social identity of the group, and participation allows individuals to demonstrate a belonging. . .there are as many types of dances as there are communities with distinct identities.

Of course, I like this choice of examples. I think that dance illustrates what I see as a trend in recent decades toward narrower, deeper, older.

One of the central scientific studies in the book is the social learning strategies tournament. In the tournament, each player faces an environment that changes gradually over a sequence of turns. To cope with this environment, at each turn the player can choose one of three moves. Quoting from the article,

INNOVATE, OBSERVE and EXPLOIT. INNOVATE represented asocial learning, that is individual learning stemming solely through direct interaction with the environment, for example, through trial-and-error. An INNOVATE move always returned accurate information about the payoff of a randomly selected behavior previously unknown to the agent. OBSERVE represented any form of social learning or copying through which an agent could acquire a behavior performed by another individual, whether by observation of or interaction with that individual An OBSERVE move returned noisy information about the behavior and payoff currently being demonstrated in the population by one or more other agents playing EXPLOIT. . . Finally, EXPLOIT represented the performance of a behavior from the agent’s repertoire

As long as the environment stays reasonably stable, you profit most from EXPLOIT. But as the environment changes, you can obtain higher payoffs by learning. In the simulation exercise conducted in the study, the social learning strategy OBSERVE worked much better than the asocial learning strategy INNOVATE. It seems to me that people who play OBSERVE get to free ride on others who are playing EXPLOIT and to free ride especially profitably on others who play INNOVATE.

Think of a factory worker in Ohio in 1999. If you just go to work every day expecting your job to last forever, you are playing EXPLOIT. If you decide to study the career choices and location decisions of people you think are similar to you, you are playing OBSERVE. If you decide to pick a new career and/or location based mostly on your own instincts, you are playing INNOVATE. The signals you get from playing OBSERVE are noisy. You could end up copying someone who develops computer network management skills and moves somewhere to run a data center. Or you could end up copying someone who goes on disability and gets addicted to opioids.

I think that this very simple model helps one to think about the PSST story for a recession. During boom times, people find patterns of specialization and trade that are rewarding, and they EXPLOIT them. But people may over-estimate the stability of that environment. They think that house prices will never go down. They think that manufacturing jobs are going to last. Then, as the environment changes and as those changes become manifest, a lot of people’s EXPLOIT strategies start to work out badly. They have to go into learning mode. They are used to having OBSERVE work out best, and that may still be the case from the perspective of the individual, but it means that the process of establishing new patterns of specialization and trade will take a long time. To speed up that process, from a social perspective we may need more people to play INNOVATE.

Anyway, there is a lot to the book, and I plan to write a fuller review.

Macroeconomics is just restin’

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The parrot is not dead, insists Ricardo Reis.

these dissertation theses are fairly representative of what modern research in macroeconomics looks like. . .

used micro data to show that it is mostly young people who adjust their consumption when monetary policy changes interest rates. Younger people are more likely to obtain a new mortgage once interest rate changes, either to buy a new home or to refinance an old one, and to spend new available funds. Her research has painstaking empirical work that focuses on the role of mortgages and their refinancing features, and a model with much heterogeneity across households…

There is more at the link. Pointer from Tyler Cowen.

Work of the sort described above sounds promising. It differs from traditional macroeconomics in a refreshing way.
Traditional macroeconomists take some very dodgy averages and call them “aggregates.” If that practice comes to be replaced by work that takes seriously the variation that underlies the averages, then we will have reason to celebrate. Unfortunately, many of the other papers Reis describes sound to me more like traditional macroeconomics.

What is wrong with the aggregation exercise? Just off the top of my head:

1. Wages and unemployment rates vary by demographic groups more than the aggregate wage and unemployment rate vary over the medium run (which is the typical period for macroeconomic analysis.

2. Inflation rates vary more across industries (health care vs. computer chips) than the average inflation rate varies over the medium run.

3. Saving rates vary more by household characteristics (including cultural background) than they vary over the medium run.

4. Much of work does not produce final output. Instead, much of the labor force has become Garett Jones workers, producing organizational capability.

5. There has been a steady increase in hard-to-measure components of the economy: the value of medical services; the value of employee benefits; the value of consumers’ surplus derived from information and communication technology; etc.

My preferred alternative to traditional macro is PSST. Traditional macroeconomists are more likely to think in terms of a single labor market. In the PSST view, unemployment is a phenomenon that results when patterns of specialization need to be reconfigured. Thinking in terms of a single labor market model is wrong-footed from the get-go.

Applying Nondiscrimination to Markets

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Mark J. Perry writes,

Although workers outside the US are not protected by US civil rights laws, doesn’t “Buy America” legislation still make it legal to discriminate against workers in Mexico, China and Russia who make iron and steel by denying them equal access to employment opportunities for infrastructure projects spending taxpayer dollars? Should that worker discrimination based on national origin from “Buy America” legislation be acceptable if discrimination against those same workers would be illegal if they were on this side of an imaginary line called the US border?

It will be a great day when the ethics of “buy American” and “buy local” are viewed skeptically.

John Cochrane on Economic Methods

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Commenting on Russ’ essay, he writes,

Economics and economic history also teach us humility: No economist in 1900 could have figured out what farmers, horse-shoers, ice deliverers, street-sweepers, and so forth would do when those jobs disappeared. The people involved did. Knowledge of our own ignorance is useful. Contemplating the railroad in 1830, no economist could have anticipated the whole new industries and patterns of economic activity that it would bring — that cows would be shipped from Kansas to Chicago, and give rise to its fabled meat-packing industry. So, in a dynamic economy, all the horse-drivers, stagecoach manufacturers, canal boat drivers, canal diggers, and so forth put out of work by the railroad, and their children, were not, in the end, immiserized.

An Economy is not a Business

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Don Boudreaux writes,

Samuelson here, like many noneconomists, fell victim to the fallacy of composition. Wars that make certain farmers and industrialists (and their workers and suppliers) more prosperous do not thereby make society more prosperous. What is true for some in this case is emphatically not true for the group.

I have pointed out that the intuitive appeal of Keynesian economics rests on the idea that the economy is a business. If a business had more demand, it probably would hire more workers. So you might think that if an economy has unemployment, it must need more demand. In fact, the point of PSST is that unemployment is a problem of not knowing which patterns of specialization and trade are sustainable. It is an entrepreneurial discovery problem, not a demand problem.

Robert Skidelsky on Economic Methods

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A month ago, he wrote,

If you believe that economies are like machines, you are likely to view economic problems as essentially mathematical problems. The efficient state of the economy, general equilibrium, is a solution to a system of simultaneous equations. Deviations from equilibrium are “frictions,” mere “bumps in the road”; barring them, outcomes are pre-determined and optimal. Unfortunately, the frictions that disrupt the machine’s smooth operation are human beings. One can understand why economists trained in this way were seduced by financial models that implied that banks had virtually eliminated risk.

Good economists have always understood that this method has severe limitations. They use their discipline as a kind of mental hygiene to protect against the grossest errors in thinking. John Maynard Keynes warned his students against trying to “precise everything away.” There is no formal model in his great book The General Theory of Employment, Interest, and Money. He chose to leave the mathematical formalization to others, because he wanted his readers (fellow economists, not the general public) to catch the “intuition” of what he was saying.

Those paragraphs would have fit into Specialization and Trade, particularly the first sentence of the first paragraph.

My view of Keynes’ “intuition” is that it is very appealing but ultimately misleading. I am thinking in particular of the “spending causes jobs” and “jobs cause spending” intuition that is what passes for Keynesian economics in the press. In real economics, you cannot just posit quantity-quantity interactions without any prices involved.

By the way, Skidelsky’s three-volume biography of Keynes (not the abridged version) really is the best thing you can read on “what Keynes really meant.” He really gets at Keynes’ views on the psychology of saving (or hoarding) and investing. I do not think that “animal spirits” means what Akerlof, Shiller, and nearly everyone else thinks it means– bouts of optimism or pessimism. I think it probably is closer to the drive for reproduction, or for immortality. Mr. Trump built his towers to try to give his name a lasting presence, not because he had a burst of optimism about real estate investment.