Category Archives: PSST and Macro

Ricardo Hausmann on Specialization and Trade

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He writes,

a market economy encourages specialization: We become very good in a narrow set of skills or products, and exchange them for millions of other things we have no clue how to do or make. As a consequence, we end up doing remarkably few things and buying everything else from others.

Pointer from Mark Thoma.

The Book of Arnold starts this way. Hausmann’s main point is that industries that compete in world markets tend to progress more rapidly than local industries.

One thought I have is that national retail chains have forced retail to become more competitive. The resistance of some countries, such as Japan, to competition in retail have held back their economies.

Another thought I have is that there is much resistance to competition in the U.S. in health care and education.

Is Larry Summers Getting Ready to Ditch Secular Stagnation?

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He starts with the puzzle that employment and measured productivity growth have both been weak. If we are replacing less-skilled workers with machines and more-skilled workers, then why isn’t labor productivity going up?

This leads Summers to suggest that labor productivity is going up, but this is not being captured in the productivity statistics.

I am struck that there is likely what may well be an increase in unmeasured quality improvement. To take the first example that comes to mind and I’ll do an experiment with this group. I’ve done this experiment with other groups – which would you rather have for you and your family, 1980 healthcare at 1980 prices or 2015 healthcare at 2015 prices? How many people would prefer 1980 healthcare at 1980 prices? How many people would prefer 2015 healthcare at 2015 prices?

There are a fair number of abstainers but your answer was pretty clear. What does that mean? That means that healthcare inflation was negative from 1980. That is very different than the 6% or so that is reflected in the
national income accounts.

Again, thanks to Mark Thoma and Tyler Cowen for pointers.

My thoughts:

1. Since people do not face health care costs directly (with their own money), perhaps this is not a fair question.

2. What about Hansonian medicine?

3. And yet, I agree with Summers on this. I certainly would prefer today’s health care at today’s prices. One of the first points I made in Crisis of Abundance is that we could afford to give everyone in the U.S. the health care of 1970. The main reason we are spending more on health care today is that it is more capital intensive and more specialist intensive. (Incidentally, I predicted when Crisis of Abundance was published in 2006 that its relevance would last a decade. I am now confident that it will be relevant even longer.)

4. Ask Summers’ question about higher education. Would you prefer a 1980 college education at 1980 tuition or 2015 college education at 2015 tuition? Personally, I see no reason to choose the latter.

In some sense, it does not matter whether Summers’ point is valid. Productivity has been been going up quite well in manufacturing and in some other sectors (e.g., Walmart). However, labor is shifting to the New Commanding Heights sectors. Maybe productivity is rising in those sectors and inflation is over-stated, or maybe they suffer from Baumol’s cost disease and there is no overstatement of inflation. Either way, once we ditch the GDP factory and disaggregate the economy, the productivity puzzle goes away.

Summers points out that if you take the view that inflation is lower than what is measured, then real interest rates are higher than typically measured. This is not good for his previous views on secular stagnation, as he points out:

to be fair [it]has an implication for views that I and others have expressed about secular stagnation, at one level you can say, well real interest rates really aren’t that low once you subtract inflation. Once you subtract properly measured inflation, there has been less of a decline in real interest rates than we thought.

And what if we think about a disaggregated economy, with deflation in some sectors and inflation in others? Does it even make sense to talk about “the” real interest rate? Obviously for a business, it is the rate of price change in your sector that matters. For a household, you care about some average rate of price change, but which average? My girls are done with schooling, so do I care about college tuition changes? Does it matter to me whether health care inflation is overstated or not, given that my only option is to purchase health insurance at current prices?

“Secular stagnation” is anachronistic, AS-AD, GDP-factory thinking. We are in a specialized economy. Eventually, otehr economists are going to come around to PSST.

Is Larry Summers Getting Ready to Ditch AS-AD?

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Both Tyler Cowen and Mark Thoma point to a discussion by Larry Summers.

I want to argue that the traditional oppositional pairing of supply side secular stagnation and demand side secular stagnation is more of a confusion, than a truth.

His current approach involves thinking about interactions between aggregate supply and aggregate demand. I hope the next stage in his thinking, and that of other macroeconomists, is to ditch AS-AD altogether. Don’t think of the economy as a GDP factory!

Instead, think in terms of a specialized economy. It is affected by secular trends, such as labor force participation increasing for women and decreasing for men from 1970-2000. It is affected by adjustment problems, such as the oil shock of the 1970s or the house-price and mortgage debt crash of 2008.

Scott Sumner on the Great Depression

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His book will be out soon, and no doubt it will break into my earlier list. Meanwhile, he has posted a really useful flowchart summary.

My own views.

All recession are adjustment problems. The Great Depression’s adjustment problems included:

1. Massive reconfiguration of agriculture because of tractors, trucking, and refrigeration. This displaced farm laborers.

2. Massive reconfiguration of manufacturing, as the small electric motor changed many production processes. As Amy Sue Bix points out, as of 1920 there were still men rolling cigars and making light bulbs by blowing glass. Machines could to those jobs better.

3. Sudden changes in asset prices, as a land bubble burst in the late 1920s and a stock market bubble burst in 1929.

4. The rise of fascism/socialism in Europe and a fear of something similar here–regime uncertainty, to use Robert Higgs’ term.

5. Counterproductive New Deal initiatives, such as destroying pigs and organizing industry into cartels (the NRA).

6. Loss of trust in financial intermediaries.

7. Increase in international protectionism.

My Macro Framework

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Scott Sumner and Tyler Cowen have given you theirs. Here is mine.

1. Ditch the concepts of aggregate supply and aggregate demand. Thinking of the economy as if it were a single business, what I call the GDP factory, is misleading. Also, there are two versions of aggregate supply, and no one can keep them straight. Version I treats the GDP factory as operating in a world without prices, or with fixed prices. Version II treats the GDP factory as operating with a sticky nominal wage, so that the profitability of output increases with price.

2. Instead, think of all recessions as adjustment problems. We are in a specialized economy, and at any point in time some people are employed in ways that do not earn a profit. These jobs are unsustainable, and the workers will be let go. Sometimes, the dislocation is temporary, and they can go back to their old jobs. But often the dislocation is permanent.

3. Arriving at sustainable patterns of specialization and trade requires two types of adjustment: static adjustment and dynamic adjustment.

4. Static adjustment means solving for the price vector that clears all markets. What I called Version II is an example of a static adjustment problem–getting “the” real wage to adjust the right level. This problem might exist, but I think it is at most one of many adjustment problems.

5. Dynamic adjustment means entrepreneurial trial-and-error to come up with businesses that employ otherwise-idle workers at a profit. Mathematical models are mostly focused on static adjustment problems, but I think primarily in terms of dynamic adjustment problems.

6. Adjustment is how we get out of a mess. How do we get into messes? To some extent, each unhappy economy is unhappy in its own way. But some elements that one tends to find include Minsky-Kindleberger manias and crashes, sudden changes in credit conditions, sharp movements in important relative prices (oil, home prices), and permanent shifts in the skill structure of work.

7. Kindleberger has a useful concept, which he calls “displacement,” which causes a large shift in wealth. For example, after a war, the winning side can feel wealthier. A bundle of technological innovations or new trading opportunities can have the same effect. The sense of increased wealth that arises from displacement can evolve into a mania. A decade after the end of the first World War, the U.S. experienced a mania. A decade after the end of the Cold War, the U.S. experienced first an Internet mania and then a housing mania.

8. Manias can create unsustainable patterns of specialization and trade and postpone the adjustment to deeper structural change. The mania of the 1920s helped to temporarily disguise the impact of the adjustment to the tractor, the truck, and the electric motor. Many jobs involving manual labor in factories and farms were becoming unsustainable. Ultimately, many of the new jobs were in wholesale and retail trade, but these jobs typically required a high school education. An important part of the adjustment process was that by 1950 a generation of poorly-educated workers had aged out of the labor force. Meanwhile, the U.S. experienced the Great Depression of the 1930s.

9. Similarly, the housing mania of the early 2000s helped to temporarily disguise the impact of the adjustment to the changes brought about by the Internet and globalization. Once again, the composition of the work force appears to be undergoing a shift, as signified by the low rate of labor force participation.

Larry Summers Finds an Anomaly

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He writes,

We find that in the vast majority of cases output never returns to previous trends. Indeed there appear to be more cases where recessions reduce the subsequent growth of output than where output returns to trend. In other words “super hysteresis” to use Larry Ball’s term is more frequent than “no hysteresis.”

Pointer from Mark Thoma.

In the AS-AD paradigm, AS and AD are independent equations. The long-run aggregate supply curve is what the economy departs from when it goes into recession and what it returns to when there is a recovery. What Summers and co-authors are finding is that the economy is more like Charlie and the MTA. It never returns to the previous long-run aggregate supply curve, and instead the aggregate supply curve appears to shift adversely in response to recessions.

Summers’ explanation for the anomaly might be that when people lose their jobs they lose some of their skills. However, another explanation that fits the data is that people who lose their jobs lose them because their skills were valuable only in patterns of specialization and trade that are no longer sustainable.

Summers points to this paper, where he and Antonio Fatas find a correlation between fiscal consolidations and downward revisions to potential GDP. I worry that both fiscal consolidation (trying to reduce unsustainable budget deficits) and downward revisions to potential GDP would be lagged responses to adverse “supply shocks” (or, in my preferred framework, an unusually large number of specialization and trade patterns becoming unsustainable).

Which Phillips Curve?

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Robert Waldmann gives us what I think of as the textbook version.

With high unemployment and low expected inflation, many wage changes will be zero & stuck at the lower bound. higher constant not accelerating inflation relaxes this lower bound (which is that nominal wage changes can’t be negative). This causes higher employment (and lower real wages).

Pointer from Mark Thoma.

A week ago, I pointed out that the Alan Krueger version of the Phillips Curve tells the opposite story: real wages rise with employment.

Of course, as Waldmann points out, there are multiple labor markets. One can conceive of real wages rising on average but falling in other labor markets, with the latter generating the increase in employment.

I continue to say that in economics, we do not produce falsification. Instead, all of our theories must contend with empirical anomalies. We have to use judgment to decide when the anomalies are numerous enough and serious enough to warrant doing without the theory. I have reached that point with Keynesian macro.

However, I do believe that thinking in terms of multiple labor markets is going to put you ahead of the game relative to those who think in terms of homogeneous workers in the national GDP factory.

Wray on Minsky

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My review of the book says,

While L. Randall Wray also praises Minsky for his anticipation of the financial crisis of 2008, he provides a much more nuanced and complete picture of Minsky’s analytical framework than I had encountered previously. While I am not completely converted, I came away from the book with considerably more understanding of Minsky’s views and a greater respect for them.

I still consider this one of the best books of the year.

Saving and Investment with Rapid Depreciation

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Tyler Cowen writes,

it seems to me highly premature to assume we know what is going on with short-term negative real rates

Let me try to tell the disinflation story again. Suppose that most capital goods these days have computing devices built into them. Consequently, there is rapid improvement in capital. This in turn means that:

1. Today’s capital goods are much more productive then yesterday’s.

2. The real price of capital goods is falling over time.

3. Depreciation of existing capital goods is rapid. What you buy today is obsolete in a few years.

I teach students a basic formula for the profitability of buying a durable good:

profitability = rental rate + appreciation – interest cost

Suppose that the rental rate on new capital is very high. That is, it is very productive. However, the appreciation rate is very negative. You may need a negative interest rate to convince you that it is profitable to obtain capital.

What else would be true if this were the story? Assets that do not depreciate would be very attractive. So if you believe that real estate does not depreciate, you want to invest in it. If you believe that corporate “brand value” does not depreciate it, you want to buy shares in firms that have a lot of brand value.

More needs to be worked out.

How Bad is Financialization?

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Noah Smith writes,

For a long time, and especially since the financial crisis, many people have suspected that financialization is bad for an economy. There is something unsettling about watching the financial sector become a bigger and bigger part of what people do for a living. After all, finance is all about allocation of resources — pushing asset prices toward their correct value so businesses can know what projects to invest in. But when a huge percent of a country’s effort and capital are put into finance, there are less and less resources to reallocate. We can’t all get rich trading houses and bonds back and forth.

Pointer from Mark Thoma.

1. Economists have no idea how to measure the value created by the financial sector. Ask any economist the following question: how should we define/measure the output of a commercial bank? You will hear the sound of crickets–even among economists who purport to study economies of scale in banking! An even more difficult question is how to measure the output of an investment bank.

2. Mathematical economics, notably the Arrow-Debreu general equilibrium model, implies that the value produced by the financial sector is exactly zero. Note Smith’s phrase “pushing asset prices toward their correct value.” This strikes me as a very truncated view of the role of financial institutions, but even so it is ruled out by Arrow-Debreu, in which prices are determined by a set of equations without any agent in the economy doing any “pushing.”

What should we conclude from (1) and (2)? One possibility is that the value of the financial sector is close to zero. The other possibility is that the cult of mathematical modeling has left economists unable to describe the role of financial institutions in the economy. My money is on this latter possibility.

Economists’ analysis of the financial sector is close to 100 percent mood affiliation. You will find many economists who are convinced that the failure of Lehman Brothers had major economic effects. You will not find a carefully worked-out verbal description of this, much less a mathematical model.

Note that I do not cheer for large banks or for mortgage securitization. My thinking on the financial sector is spelled out more in the Book of Arnold.

Here, the point I am trying to make is that not having a grasp on what financial institutions do should be an indictment of economists, not of the financial sector.