Category Archives: PSST and Macro

Minsky Revisited

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Olivier Blanchard says,

mainstream macroeconomics had taken the financial system for granted. The typical macro treatment of finance was a set of arbitrage equations, under the assumption that we did not need to look at who was doing what on Wall Street. That turned out to be badly wrong. . .

…As a result of the crisis, a hundred intellectual flowers are blooming. Some are very old flowers: Hyman Minsky’s financial instability hypothesis. . .

Pointer from Mark Thoma.

I have just finished a first reading of a review copy of L. Randall Wray’s forthcoming Why Minsky Matters. It is certain to be on my list of best books of the year. In my opinion, Wray succeeds in clarifying Minsky and in making his views more interesting and persuasive to me than they were previously (I still have my quarrels).

If I think about the economy in terms of patterns of specialization and trade, then Minsky thought of it in terms of financial intermediation. For Minsky, all of us are intermediaries. Because we do not barter, we trade either by issuing IOU’s or by passing along the IOU’s of others (fiat currency being an IOU of the government, if you will).

I am working on a review, which probably will not be out before the book.

Paul Krugman’s Keynesian Framework

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AS Mark Thoma echoes, Krugman writes,

1. Economies sometimes produce much less than they could, and employ many fewer workers than they should, because there just isn’t enough spending. Such episodes can happen for a variety of reasons; the question is how to respond.

2. There are normally forces that tend to push the economy back toward full employment. But they work slowly; a hands-off policy toward depressed economies means accepting a long, unnecessary period of pain.

3. It is often possible to drastically shorten this period of pain and greatly reduce the human and financial losses by “printing money”, using the central bank’s power of currency creation to push interest rates down.

4. Sometimes, however, monetary policy loses its effectiveness, especially when rates are close to zero. In that case temporary deficit spending can provide a useful boost. And conversely, fiscal austerity in a depressed economy imposes large economic losses.

Note that there are no microfoundations anywhere. Which is fine, in the sense that microfoundations do not add anything to this framework. They do not make it more rigorous, in my view, because they squeeze the economy into a GDP factory.

Of course, I have a different framework, starting with point 1. I think that the drop in spending during a recession is like the thunder that comes during a storm. The thunder does not cause the storm, nor does the drop in spending cause the recession. See may essays on PSST if you need my views in more detail.

The Basic Social Rule

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My latest essay:

I claim here that humans have a fundamental rule of social morality, which is: Reward cooperators; punish defectors. The use of this rule is what enables humans to work effectively with strangers, making possible sophisticated economies and civilizations. However, this rule can cause problems when people mis-classify the social actions of others.

Please read the whole thing and comment. These are ideas that I also plan to include in the Book of Arnold.

Kicking China when it’s Down

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Yasheng Huang writes,

The lasting contributions of infrastructures come from their usage, not from their construction. This is why a bridge to nowhere can boost GDP temporarily, but it has no long-run positive effect. On that, China falls short. It has several “ghost cities,” rows and rows of apartment buildings that are unsold and vacant, and lightly utilized highways and airports.

He makes it sound like China has the socialist calculation problem in spades.

Ancient Trade and Trust

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1. From Adam Davidson in the NYT magazine:

At the city gate, Assur-idi ran into a younger acquaintance, Sharrum-Adad, who said he was heading on the same journey. He offered to take the older man’s donkeys with him and ship the profits back. The two struck a hurried agreement and wrote it up, though they forgot to record some details. Later, Sharrum-­Adad claimed he never knew how many textiles he had been given.

Pointer from Tyler Cowen.

This apparently took place in the 19th century, BC. Long-time readers will know that I have taken the view that archaelogists are finding evidence of plunder and calling it evidence of trade. But this example (read the whole story) shows that I am wrong about that.

The main focus of the article is the gravity model of trade, which says that trade between any two entities (cities, countries) is positively related to their size in terms of population and negatively related to the distance between them.

2. Josiah Ober says,

The key to unlocking the puzzling success of the Greek city-state ecology is economic specialization and exchange. Specialization was based on developing and exploiting a local advantage, relative to other producers, in the production of some valued good or service. . .

the costs of transactions were driven down by continuous institutional innovations, notably by the development and rapid spread of silver coinage as a reliable exchange medium; the dissemination of common standards for weights and measures; the creation of market regulations and officials to enforce them; and increasingly sophisticated systems of law and legal mechanisms for dispute resolution.

The whole piece is interesting.

Can Computers Solve the Socialist Calculation Problem?

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Malcolm Harris writes,

What if the problem with the Soviet Union was that it was too early? What if our computer processing power and behavioral data are developed enough now that central planning could outperform the market in the distribution of goods and services?

Pointer from Tyler Cowen.

This is just sad. The socialist calculation problem is not one of processing power. In The Book of Arnold, I try to explain it thusly:

In a command economy, central planners give each family ration coupons for corn flakes and wheat bread. If you were to give a family more ration coupons for corn flakes, then the family would gladly use them. If you were to give a family more ration coupons for wheat bread, then the family would gladly use those. Consumers have no way of signaling to planners that in relative terms they would prefer more corn flakes.

Similarly, workers have no way of signaling to central planners that they have untapped skills. Managers have no way of signaling that there are alternative production methods that might use a lower-cost combination of inputs. Indeed, the central planners do not know the cost of inputs. They only know the shadow prices that they have imputed to those inputs.

The Econometrician and the Entrepreneur

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Don Boudreaux writes,

The market itself is a vast and on-going laboratory of experiments – experiments that are relevant, real, and revealing. These experiments are valuable not least because they are made under real-world circumstances and by people with strong personal incentives to discover and comprehend the ‘truth’ better than their rival experimenters. . .

While I sincerely believe that much useful information can be gathered by academics doing empirical studies (both quantitative and non-quantitative), it is an unwarranted conceit of academics to suppose themselves and their empirical studies to be the only, or even the chief, source of empirical knowledge of social reality.

The notion that markets generate and process information must be very non-intuitive. It strikes me as under-appreciated by many people, including economists. Of course, markets lack perfect information–otherwise there would be no flawed products, no business failures, and no financial crises. But I am not arguing that the market process has generated perfect information. I am simply suggesting that it is hard for someone–even someone armed with a lot of data and a computer–to be more informed than the market.

The State of the Phillips Curve

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John Cochrane writes,

There is supposed to be a stable negatively sloped curve here by which higher inflation comes with lower unemployment. Beyond that correlation, most policy economists read it as cause and effect, higher unemployment begets lower inflation and vice versa. The point of the article is how little reality conforms to that bedrock belief.

He refers to a WSJ article with an amusing chart in accompaniment.

The Phillips Curve famously began as an empirical finding in search of a theory. For several decades, it has been a theoretical relationship in search of empirical support.

In the Book of Arnold, I write,

In normal times, most prices remain stable, with some prices rising and some prices falling. Changes in relative prices (prices of computers falling, college tuition rising) are much more dramatic than changes in the overall rate of inflation.

Over the past 70 years, inflation in the United States has typically stayed in a range of 1 to 5 percent. However, inflation broke out of that range significantly in the 1970s, reaching highs of close to 15 percent. In the early 1980s, inflation began to ebb, receding to its normal range by the end of the decade.

The orthodox view of the 1970s inflation is that the acceleration was caused by excessive monetary growth and it was ended by a change in Federal Reserve policy that reduced the rate of money creation. My unorthodox view is not as well positioned to explain these movements. One possible alternative explanation is that the habitual behavior of people changed. They began to expect high inflation, and they factored such expectations into labor contracts and other long-term arrangements.

In my view, the 1970s through the mid 1980s are the only important inflation event in post-war American macro history. Whatever explains the behavior of inflation in that period, the Phillips Curve is not the story. An “expectations-augmented Phillips Curve” will fit, but primarily because of the expectations term. The idea that inflation develops momentum because of expectations strikes me as sound. The empirical support for other factors is mostly of the form of confirmation bias.

Markets and Trust

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Liran Einav, Chiara Farronato, and Jonathan Levin write,

Businesses that hope to create successful marketplaces or platforms for matching buyers and sellers have to solve several problems. They need to help buyers and sellers Önd each other, either by developing a centralized assignment mechanism or by allowing for e§ective search. They need to set prices that balance demand and supply, or alternatively ensure that prices are set competitively in a decentralized fashion. And importantly, they have to maintain an adequate level of trust in the market, by developing mechanisms to guard against low quality, misbehavior and outright fraud.

In The Book of Arnold, I write,

In the 21st century, many of us shop on the Internet. How do I know that the biking gloves I order really have the padding that I want? How do I know that the retailer will send me the gloves that I order? How do I know that the gloves will not be stolen before they reach me?

When you consider these sorts of questions, you realize that our modern market economy is built on layers of trust. In order for trade to take place, individual beliefs, cultural norms, and formal institutions must be aligned to reinforce such trust.

The catch is that almost every mechanism for promoting trust has flaws and can be abused.

Ray Fair on Macroeconometrics

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He writes,

Take a typical consumption function where consumption depends on current income and other things. Income is endogenous. In CC models using 2SLS, first stage regressors might include variables like government spending and tax rates, possibly lagged one quarter. Also, lagged endogenous variables might be used like lagged investment. If the error term in the consumption equation is serially correlated, it is easy to get rid of the serial correlation by estimating the serial correlation coefficients along with the structural coefficients in the equation. So assume that the remaining error term is iid. This error term is correlated with current income, but not with the first stage regressors, so consistent estimates can be obtained. This would not work and the equation would not be identified if all the first stage regressors were also explanatory variables in the equation, which is the identification criticism. However, it seems unlikely that all these variables are in the equation. Given that income is in the equation, why would government spending or tax rates or lagged investment also be in? In the CC framework, there are many zero restrictions for each structural equation, and so identification is rarely a problem. Theory rules out many variables per equation.

Pointer from Mark Thoma.

I am afraid that Ray Fair leaves out the main reason that I dismiss macroeconometric models, namely the “specification search” problem. As you can gather from the quoted paragraph, there are many ways to specify a macroeconometric model. Fair and other practitioners of his methods will try dozens of specifications before settling on an equation. As Edward Leamer pointed out in his book on specification searches, this process destroys the scientific/statistical basis of the model.

I have much more to say on this issue, both in my Science of Hubris paper and in my Memoirs of a Would-be Macroeconomist. In the latter, I recount the course that I took with Fair when he was a visiting professor at MIT.

Other remarks:

1. On DSGE, I think that the main vice is the “representative agent” consolidation. It completely goes against the specialization and trade way of thinking. Fighting the whole “representative agent” modeling approach is a major point of the Book of Arnold, or at least it is supposed to be. (I may have been too terse in the macro section of my first draft.)

2. VAR models are just a stupid waste of time. As I said in a previous post, we do not have the luxury of saying that we construct models that correspond with reality. What models do is allow us to describe what a possible world would look like, given the assumptions that are built into it. VAR models do not build in assumptions in any interesting way. That is claimed to be a feature, but in fact it is a huge bug.

I think that the project of building a model of the entire economy is unworkable, because the economy as whole consists of patterns of specialization and trade that are too complex to be captures in a model. But if you forced me to choose between VAR, DSGE, and the old-fashioned stuff Fair does, I would actually use that. At least his model can be used to make interesting statements about the relationship of assumptions to predicted outcomes. But that is all it is good for, and for my money you are just as well off making up something on the back of an envelope.