Category Archives: PSST and Macro

Taking Macroeconomics Backward Through Regression

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Olivier Blanchard recently wrote that there ought to be two classes of macroeconomic models.

Theory models, aimed at clarifying theoretical issues within a general equilibrium setting. Models in this class should build on a core analytical frame and have a tight theoretical structure. They should be used to think, for example, about the effects of higher required capital ratios for banks, or the effects of public debt management, or the effects of particular forms of unconventional monetary policy. The core frame should be one that is widely accepted as a starting point and that can accommodate additional distortions. In short, it should facilitate the debate among macro theorists.

Policy models, aimed at analyzing actual macroeconomic policy issues. Models in this class should fit the main characteristics of the data, including dynamics, and allow for policy analysis and counterfactuals. They should be used to think, for example, about the quantitative effects of a slowdown in China on the United States, or the effects of a US fiscal expansion on emerging markets.

In response, Simon Wren-Lewis rejoiced,

Ever since I started blogging I have written posts … to try and convince fellow macroeconomists that Structural Econometric Models (SEMs), with their ad hoc blend of theory and data fitting, were not some old fashioned dinosaur, but a perfectly viable way to do macroeconomics and macroeconomic policy.

Pointers from Mark Thoma.

For why Blanchard and Wren-Lewis are wrong, see my essay Macroeconometrics: the Science of Hubris. If the profession follows their advice, macroeconomics will be regressing in every sense of the word.

Gita Gopinath on Trade and Exchange Rates

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She says,

most of trade invoicing is done in dollars. More recent research shows that these dollar prices tend to be sticky—that is, these dollar prices are far more stable than exchange rates. For non-U.S. economies, therefore, a depreciation of their currency relative to the dollar leads to almost a one-to-one increase in the price of imported goods in their own currency and, therefore, the pressures on inflation are high. On the other hand, because dollar prices of traded goods are relatively stable, the inflationary pressures on the U.S. economy are weak.

Pointer from Timothy Taylor.

It is as if there has been a bottom-up decision to stabilize the purchasing power of the dollar. That consensual hallucination makes U.S. monetary policy less effective at wiggling the inflation rate.

Later, she says,

we instead explored the role of value-added taxes and payroll subsidies or, more specifically, raising value-added taxes and cutting payroll taxes. What we found, surprisingly, is that this form of intervention did extremely well in mimicking the outcomes of a currency devaluation, not approximately but exactly.

The point is that a country like Italy or Greece is not trapped by being in the euro. It could increase its competitiveness by raising value-added taxes on consumption and cutting payroll taxes.

I recommend the entire interview. I do not buy everything she says, but it is all interesting.

Still Looking for a Present?

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Yuval Levin recommends my book, among others.

It helps you unlearn what is untrue and then try to learn what is true. And it treats economics as a discipline—that is, not just a set of tools and facts but an ongoing project engaged in by real human beings with a purpose and a history and all manner of virtues and vices. It seems to me that we are living through something of a crisis in economic theory at the moment (not for the first time), and Kling can help us through it.

Supply, Demand, and Immigration

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Don Boudreaux writes,

An increase in the supply of labor lowers wages only if nothing else changes. But when immigrants enter the workforce two very important other things change. First, immigrant workers spend or invest their earnings, both of which activities increase the demand for labor – thus putting upward pressure on wages. By focusing only on immigrants’ effect on the supply of labor, Mr. Burwell overlooks immigrants’ effect on the demand for labor.

A second change is one that was emphasized by Adam Smith: larger supplies of workers, as well as more consumers of the economy’s output, lead to greater specialization. Jobs change. As Smith explained, this greater specialization makes workers more productive. This increased productivity, in turn, causes wages to rise.

Peter Turchin would disagree. In Ages of Discord, he finds a strong historical correlation between periods of high rates of immigration and stagnant wages for ordinary workers. I have read through Turchin’s book once, and I mean to write a review. But I keep procrastinating. I am tempted to say that the book, while it appeared to be very interesting on a first pass, is un-rereadable. The data that lands in Turchin’s charts takes a very circuitous route to get there, and it hard for me to stay on top of the relationship between the underlying data and what Turchin says that they represent.

Clayton Christensen’s PSST Story (?)

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He wrote,

There are three types of innovations. The first are “empowering” innovations. These transform complicated, costly products that previously had been available only to a few people, into simpler, cheaper products available to many. The Ford Model T was an empowering innovation, as was the Sony transistor radio.
Empowering innovations create jobs for people who build, distribute, sell and service these products.
The second type are “sustaining” innovations. These replace old products with new. The Toyota Prius hybrid is marvelous — yet every time a customer buys a Prius, a Camry is not sold. Sustaining innovations replace yesterday’s products with today’s products. They keep our economy vibrant — and, in dollars, they account for the most innovation. But they have a zero-sum effect on jobs and capital. The third type are “efficiency” innovations. These reduce the cost of making and distributing existing products and services – like Toyota’s just-in-time manufacturing in carmaking and Geico in online insurance underwriting. Efficiency innovations almost always reduce the net number of jobs in an industry, allow the same amount of work (or more) to get done using fewer people.

Pointer from James Pethokoukis.

Christensen says that you need a balance between “empowering innovations” and “efficiency innovations.” We have been getting mostly the latter, and that results in a net loss of jobs.

This sounds like a PSST story. However, I think that for the story to work, you need heterogeneity of labor. If you think of “labor” as homogeneous, then when workers in the “efficiency innovation” sector (say, manufacturing) are let go, there is some place where they could be hired (say, health care aides for the elderly). To get unemployment, you have to postulate that the adjustment takes a very long time, because labor is heterogeneous in some way. I think that’s a reasonable way to go.

Labor heterogeneity matters. The challenge is for entrepreneurs to find something profitable to do with the types of workers released by the efficiency innovations.

If government is going to fix the problem, it cannot simply throw some generic stimulus at it. The government has to figure out something that will employ the types of workers released by the efficiency innovations. To do this in a sustainable way, the government has to solve the problem better than entrepreneurs. Of course, that is unlikely.

Noah Smith on Labor Supply and Demand

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He writes,

What is a better theory of the labor market? Maybe general equilibrium (which might say that immigration creates its own demand). Maybe a model with imperfect competition (which might say that minimum wage reduces monopsony power). Maybe search and matching theory (which might say that frictions make all short-term effects pretty small). Maybe a theory with very heterogeneous types of labor. Maybe something else.

Pointer from Mark Thoma.

This is the middle of the movie, so to speak. At the start of the movie, Smith looks at two stylized facts about the short run. One is that an immigration surge has little effect on wages. This suggests that labor demand is highly elastic. The other is that a minimum wage increase has little effect on employment. This suggests that labor demand is highly inelastic. It cannot be both.

Of course, you do have the option of denying the veracity of one or both stylized facts. But I do not want to go there. I vote for “very heterogeneous types of labor.” There is no such thing as “aggregate labor demand” in the labor market. There are patterns of specialization and trade. And these tend to be sticky, both in terms of wages and the quantity of each type of worker employed.

The “labor market diagram” makes it appear that you can have either a sticky wage or a sticky quantity of labor, but not both. Behind this (false) theorem lies the presumption that it is very easy to substitute among workers. This is an instance in which mathematical modeling serves to confound rather than help the modeler.

In fact, workers are specialized. Even relatively unskilled workers have been trained to perform their particular tasks. The substitutability that is implicit in the labor market diagram does not exist in the real world.

Labor market adjustment comes primarily from changes in the patterns of sustainable specialization and trade. Because it takes time for old patterns of trade to become unsustainable and for new sustainable patterns to form, neither wages nor quantities change as much in the short run as they do in the long run.

The effect of the minimum wage in the short run on existing firms can be small. They mostly just suck it up and pay the higher wage. However, over time, there will be a tendency for processes that use low-skilled workers to be less profitable and processes that instead use capital and high-skilled workers to be relatively more profitable. So the patterns of specialization and trade that break up will tend to be those that have been employing low-skilled workers, and the new ones that form will tend to employ fewer low-skilled workers than would have been the case otherwise.

As for immigration, what Noah calls general equilibrium I call creating new patterns of specialization and trade. There is no “lump of labor demand” that immigrants and natives are competing to fill. Firms do not say, “Oh, goody. Now I can now fire my native workers and hire immigrants for $1 an hour less.” Instead, entrepreneurs who are thinking of starting firms ask, “Where can I get the best workers for the least cost?” And in many cases immigrants are the answer. As this process plays out, my guess is that the main wage-depressing effect is on native workers just entering the labor force. But of course a lot of them have specialized skills that insulate them from competition from immigrants. So the effect on natives’ wages is limited in scope and stretched out in time.

Symposium on Low Interest Rates

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From the Mercatus center. The contributions are not coordinated in any way. We wrote essays about causes, effects, predictions, …whatever we felt like, on the general subject of the implications of low interest rates and the potential for them to rise. So far, we have

David Beckworth:

the 10-year Treasury yield has fallen more as a result of business-cycle pressures and policy uncertainty than because of structural changes like demographics. Consequently, more normal levels of interest rates are likely to prevail in the future.

If he is right, he could make a lot of profit by shorting bonds. And he may be right.

Joseph Gagnon writes

There are at least five reasons for the current low real rates of interest: (a) labor force growth has declined around the world, thereby reducing the need for business and housing investment; (b) a large cohort in many countries is entering the maximum saving years immediately prior to retirement; (c) productivity growth has declined around the world, thus reducing the demand for business investment; (d) regulatory changes have increased the demand for safe assets, including those that are commonly used to quote interest rates; and (e) driven by government policies, developing and emerging market economies have become net savers instead of net borrowers since 2000. In late 2009, I noted that the decline of real interest rates had been going on for about 30 years, and I pointed to several of those factors. This phenomenon is not limited to the aftermath of the Great Recession.

George Selgin writes,

Interest rates, like other prices, can change for all sorts of reasons; the implications of the change generally depend on the particular reason for such a change.

I had the same problem that Selgin had in starting the discussion with the value of an endogenous variable. I wrote,

The fiscal effect of an interest rate change depends on the source for that change. The source could be an increase in real economic growth, an increase in inflation, or an increase in the risk premium that investors assign to government securities.

Will Trump Revive Liberal Economists?

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Justin Wolfers writes,

you should think of the economy as being in a state of constant churn. The economist Joseph Schumpeter used the now-famous phrase “creative destruction” to describe this process by which new firms push out the old. The result can be cruel, but an extraordinarily fluid labor market, many economists argue, is the secret of American dynamism.

Wolfers tells a PSST story using a metaphor of a parking garage. The metaphor works a bit awkwardly in my view, but it will suffice.

Mr. Trump is focusing his resources on existing firms — the cars already parked there — rather than on the millions of potential entrepreneurs who might open the next generation of businesses.

Pointer from Mark Thoma.

If Mr. Trump can get more center-left economists talking about the seen and the unseen and describing the economy in the way that I do in Specialization and Trade, then he will have done a great service to the profession.