The State of Macroeconomic Analysis

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Olivier Blanchard, who in August of 2008 describe it as “good,” has modified his views. Concerning the consensus methodology that he praised back then, Blanchard writes,

However, these techniques only made sense under a vision in which economic fluctuations were regular enough so that, by looking at the past, people and firms (and the econometricians who apply statistics to economics) could understand their nature and form expectations of the future; and simple enough so that small shocks had small effects, and a shock twice as big as another had twice the effect on economic activity. The reason for this assumption, called linearity, was technical. Models with nonlinearities – those in which a small shock, such as a decrease in housing prices, can sometimes have large effects, or in which the effect of a shock depends on the rest of the economic environment – were difficult, if not impossible, to solve under rational expectations.

Pointers from Mark Thoma and Greg Mankiw. Read the whole thing. I have to give Blanchard credit for writing this:

The reality of financial regulation is that new rules open new avenues for regulatory arbitrage, as institutions find loopholes in regulations. That in turn forces authorities to institute new regulations in an ongoing cat-and-mouse game (between a very adroit mouse and a less nimble cat). Staying away from dark corners will require continuous effort, not one-shot regulation.

That is the theme of The Chess Game of Financial Regulation.

However, my overall take on Blanchard’s essay will be harsh.*

1. He still wants to believe in equations and technical brilliance. He implies that if we were just better at manipulating nonlinear models, all would be well. Once again, an MIT economist is unable to grasp Hayek’s insight that there is knowledge embedded in the economic order that no individual can possess. No thanks to MIT, and long after I had left it, I wound up on the side of Hayek. In fact, when it comes to macro I would argue that I am more Hayekian than Hayek.

2. Rational expectations helped make the careers of Fischer, Blanchard, and other MIT contemporaries, and refusal to tool up in rational-expectations modeling is what un-made my own academic career. In hindsight, and with an assist from Frydman and Goldberg, I would say that rational expectations was the ultimate anti-Hayek proposition. In effect, Chicago said that everyone knows everything. Eventually, MIT countered with “behavioral economics,” which said that some people are often mistaken while assuming at least implicitly that the technocratic elites know everything.

3. My least favorite paragraph:

Now that we are more aware of nonlinearities and the dangers they pose, we should explore them further theoretically and empirically – and in all sorts of models. This is happening already, and to judge from the flow of working papers since the beginning of the crisis, it is happening on a large scale. Finance and macroeconomics in particular are becoming much better integrated, which is very good news.

I’ll be uncharitable (and sarcastic) and say that he is telling us once again that the state of macro is good, because the same modeling hubris still predominates. The way I see it, the drunks are still looking under the same lamppost.

As for integrating finance and macroeconoimcs, my prediction is that this will accomplish nothing. I believe that mainstream macroeconomists are over-stating the importance of the financial crisis. Instead, I am inclined to treat the financial crisis as a blip, one whose apparent macroeconomic impact was made somewhat worse by the very policies that mainstream economists claim were successful.

This blip took place in the context of key multi-decade trends:

–the transition away from goods-producing sectors and toward the New Commanding Heights of education and health care

–the transition of successful men away from marrying housekeepers and toward marrying successful women

–the integration of workers in other nations, most notably China and India, into the U.S. production system

–the increasing power of computer technology that ise more complementary to some workers than others

These trends are what explain the patterns of employment and relative wages that we observe. The financial crisis, and the government panic in response, pushed the impact of some of these developments forward in time. Overall, however, the focal points of mainstream macroeconomics, including fiscal and monetary measures, are not nearly as significant to the actual economy as they are on paper in the models.

I have always been harsh on Blanchard. You should discount for that.

The State of the Economy

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1. There have been several posts pointing out that wage growth has been slow, even though the unemployment rate has fallen.

2. There have been several posts, including some of mine, on low long-term interest rates. More recently, the WSJ talked with James Bullard.

Right now, “the markets are making a mistake” and expect the Fed to maintain its ultra-easy policy stance longer than Fed officials themselves currently expect, Mr. Bullard said. When it comes to these expectations, “I would prefer that those be better aligned than they are.”

3. Scott Sumner writes,

The 4-week moving average of layoffs came out today at 287,750. Total civilian employment in September was 146,600,000. The ratio of the two, i.e. the chance of being laid during a given week if you had a job, was below 2 in 1000. That’s only happened once before in all of American history–April 2000.

However,

We are even seeing a lower employment/population ratio in the key 25-54 demographic, compared to seven years ago.

Read his whole post.

On (1), I would note that a few years ago wage growth was violating the Phillips Curve on the high side, and now it is violating the Phillips Curve on the low side. And yet mainstream macroeconomists stick to the Phillips Curve like white on rice. I would emphasize that the very concept of “the” wage rate is a snare and a delusion. Yes, the Bureau of Labor Statistics measures such a thing.

Instead, think of our economy as consisting of multiple labor market segments, not tightly connected to one another. There are many different types of workers and many different types of jobs, and the mix keeps shifting. I would bet that in recent years the official statistics on “the” wage rate have been affected more by mix shifts than by a systematic relationship between “the” wage rate and “the” unemployment rate.

On (2), I view this as evidence for my minority view that the Fed is not a big factor in the bond market. Instead, the Fed is mostly just following the bond markets. When it actually tries to affect the bond market, what you get are “anomalies,” i.e., the failure of the bond market to do as expected by the Fed.

On (3), I think that we are seeing a Charles Murray economy. In Murray’s Belmont, where the affluent, high-skilled workers live, I am hearing stories of young people quitting jobs for better jobs. On the basis of anecdotes, I would say that for young graduates of top-200 colleges, the recession is finally over. The machinery of finding sustainable patterns of specialization and trade is finally cranking again.

In Murray’s Fishtown, on the other hand, the recession is not over. I would suggest that we are seeing the cumulative effects of regulations, taxes, and means-tested benefits that reduce the incentive for firms to hire low-skilled workers as well as the incentive for those workers to take jobs. As Sumner points out, President Obama’s policies have moved in the direction of making these incentives worse.

Elastic Housing Supply?

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Megan McArdle writes,

Over the past few years, developers have rectified the situation; a great deal of new housing is coming on the market. Which means the end of double-digit rent increases and housing appreciation in those cities. But we seem to have reached the end of “making up for lost time” and headed toward “glut.”

She speaks of the NY city and DC markets in particular. I admit I have wondered about the wisdom of developers treating Bethesda like beachfront property, with all the high-rise condos they are building.

But I am skeptical of her view that the shortage of housing in these urban markets is about to abate. Nationally, the rate of housing construction remains well below the normal rate of family formation. When I talk to people involved in real estate, they say that it’s not local demand that is driving prices anyway–all the talk is of “foreign money.”

But the main thing is that I do not believe that the supply of housing is really elastic in NY, DC, LA, or SF. The restrictions on development are still formidable.

The Season of Giving

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I would recommend giving your progressive friends gift subscriptions to Regulation. The articles in the current issue, as usual, show the gap between intention and outcome.

For me, the issue was too depressing to digest in one sitting. It is hard to single out any one article, but perhaps Peter Lemieux on the U.S. wanting to apply tariffs to Chinese solar panels is the one that describes a government action that even a progressive should easily find reasons to condemn.

Do you believe in respect for international law? The World Trade Organization ruled against the U.S. Do you believe in using “green” energy to fight global warming? Raising the price of solar panels will reduce the use of solar power. etc.

Heritability of Academic Performance

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Reporting on a study conducted by researchers at King’s College, this story says,

The team found nine general groups of traits that were all highly hereditary—the identical twins were more likely to share the traits than nonidentical twins—and also correlated with performance on the GCSE. Not only were traits other than intelligence correlated with GCSE scores, but these other traits also explained more than half of the total genetic basis for the test scores.

…In all, about 62% of the individual differences in academic achievement—at least when it came to GCSE scores—could be attributed to genetic factors, a number similar to previous studies’ findings

The reporter, Sarah C. P. Williams, writes,

The results may lead to new ways to improve childhood education.

She does not explain how. If anything, the results seem to me to reinforce the null hypothesis.

And note that in this article on the high correlation between parents’ wealth and childrens’ SAT scores, it’s like the writer is thinking, “I know that wealthy people buy good SAT scores for their kids, but I can’t figure out how they do it.” There is not one mention of anything related to heritability of traits. This bothered James Pethokoukis, also.

Larry Summers Favors Nirvana

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He writes,

the IMF finds that a dollar of investment increases output by nearly $3. The budgetary arithmetic associated with infrastructure investment is especially attractive at a time when there are enough unused resources that greater infrastructure investment need not come at the expense of other spending. If we are entering a period of secular stagnation, unemployed resources could be available in much of the industrial world for quite some time.

Pointer from Mark Thoma.

If we assume that government invests perfectly rationally and efficiently, then I think we have to agree that infrastructure spending is likely to be a free lunch. That is because it is impossible for the private sector to allocate resources perfectly rationally and efficiently.

Of course, in order to assume that government spends money rationally and efficiently, one has to ignore public choice theory. A bridge to nowhere is not a free lunch. A huge loan guarantee to a “green energy” company that goes bankrupt is not a free lunch.

In the real world, human fallibility does not disappear when the decision-maker crosses from the private sector to the public sector. In my area, a highway called the “Inter-County Connector” has cost billions of dollars, caused construction-related disruption for years, and carries almost no traffic. A “transit center” near where I live was structurally unsound, and the excess costs probably will be in the billions. No free lunches there, either.

David Brooks’ High-Holiday Sermon

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He said,

The way I express this contrast, this hunger for success is by two sets of virtues, which you could call the résumé virtues and the eulogy virtues. And the résumé virtues are the things you bring to the marketplace which you put on a résumé. And the eulogy virtues are the things you get expressed in your eulogy. And these are non-overlapping categories. So the eulogy virtues are to give courage, to give honor, what kind of relationships do you build, did you love.

…Adam One is the external résumé. Career-oriented. Ambitious. External.

Adam Two is the internal Adam. Adam Two wants to embody certain moral qualities to have a serene, inner character, a quiet but solid sense of right and wrong, not only to do good but to be good, to sacrifice to others, to be obedient to a transcendent truth, to have an inner soul that honors God, creation and our possibilities.

I think he should read Yuval Levin’s sermon, which you can now read for free. It is a reminder that politics is the arena for Adam One, not Adam Two.

The Wedge Between Compensation and Wages

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Mark Warshawsky and Andrew Biggs write,

Most employers pay workers a combination of wages and benefits, the most important of which is health coverage. Economic theory says that when employers’ costs for benefits like health coverage rise, they will hold back on salary increases to keep total compensation costs in check. That’s exactly what seems to have happened: Bureau of Labor Statistics data show that from June 2004 to June 2014 compensation increased by 28% while employer health-insurance costs rose by 51%. Consequently, average wages grew by just 24%.

The kicker:

Health costs are a bigger share of total compensation for lower-wage workers, and so rising health costs hit their salaries the most. The result is higher income inequality.

I don’t think you can blame company-provided health insurance as a first-order cause. Suppose that there were no company-provided health insurance, and everyone instead bought health insurance on their own. In that case, more of the compensation of employees would have been in the form of wages and salaries. If health insurance in the individual market had gone up as rapidly as it has in the company-provided market, then this would have a stronger effect on the cost of living for low-income workers. So even if you did not have company-provided health insurance, you would still have the “wedge” between compensation and disposable income after health insurance.

As a second-order effect, you can argue that company-provided health insurance, and its tax exemption, push in the direction of raising health care costs. But that is not such a compelling argument.

I do think that it is increasingly misleading to speak of a single “cost of living,” when so much of the market basket consists of medical procedures and college expenses that not everyone undertakes. That is, I still believe that Calculating trends in the real wage is much harder than we realize, because every household has different tastes.

Related, from Timothy Taylor:

it’s also intriguing to note that since 1984, the share of income spent on luxuries is rising for each income group, and the share of income spent on necessities is falling for each income group.

He refers to a study by LaVaughn M. Henry.