Category Archives: Economic education and methods

Why I Quit Macroeconomics

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We construct a microfounded, dynamic version of the IS-LM-Phillips curve model by adding two elements to the money-in-the-utility-function model of Sidrauski (1967). First, real wealth enters the utility function. The resulting Euler equation describes consumption as a decreasing function of the interest rate in steady state–the IS curve. The demand for real money balances describes consumption as an increasing function of the interest rate in steady state–the LM curve. The intersection of the IS and LM curves defines the aggregate demand (AD) curve. Second, matching frictions in the labor market create unemployment. The aggregate supply (AS) curve describes output sold for a given market tightness. Tightness adjusts to equalize AD and AS curve for any price process. With a rigid price process, this steady-state equilibrium captures Keynesian intuitions. Demand and supply shocks affect tightness, unemployment, consumption, and output. Monetary policy affects aggregate demand and can be used for stabilization. Monetary policy is ineffective in a liquidity trap with zero nominal interest rate. In contrast, with a flexible price process, aggregate demand and monetary policy are irrelevant when the nominal interest rate is positive. In a liquidity trap, monetary policy is useful if it can increase inflation. We discuss equilibrium dynamics under a Phillips curve describing the slow adjustment of prices to their flexible level in the long run.

That is the abstract of a new paper by Pascal Michaillat and Emmanuel Saez. It was while I was in graduate school that this sort of mathematical self-abuse took over the field.

Public Choice 101

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From Cathy Reisenwitz.

Earlier this year, Center for American Progress donor Citibank hired lobbyists to literally write 70 out of 85 lines of a bill regulating derivatives trading which passed the House. If this regulation was meant to hurt Citibank’s profitability while defending their customers it’s unlikely to have done so.

There are three main reasons corporations like Citibank write their own legislation. First, lawmakers feel pressure from constituents to regulate industries about which their staffs know nothing; corporate lobbyists and lawyers provide much-needed information. Second, it’s much easier and faster for a company to understand and comply with a regulation it wrote. Third, and most important, companies write regulation that is easier and cheaper to comply for them than for their competitors.

Read the whole thing. Of course, it will change no one’s mind. The way to resist public choice theory is to insist that with sufficient moral authority “we” can regulate in a non-corporatist way. That is a non-falsifiable hypothesis, because the premise of sufficient moral authority is never satisfied.

Phillips Curve Specifications and the Microfoundations Debate

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Scott Sumner writes,

As you may know I view inflation as an almost worthless concept… In contrast Krugman discusses the original version of the Phillips curve…which used wage inflation instead of price inflation. Whereas price inflation is a useless concept, wage inflation is a highly useful concept.

Fine. But Krugman also draws attention to how the level of the unemployment rate affects the level of the wage inflation rate. This takes us back to the original, pre-1970 Phillips Curve, from Act I in my terminology (Act I was the Forgotten Moderation, from 1960-1969, Act II was the Great Stagflation, from 1970-1985. Act III was the Great Moderation, from 1986-2007, and Act IV is whatever you want to call what we are in now.) The Act I Phillips Curve says flat-out that (wage) inflation will be high when unemployment is low, and vice-versa.

The Phillips Curve was revised in Act II, when the specification became that the rate of wage inflation increases when the unemployment rate is above below the NAIRU and decreases when it is belowabove the NAIRU. In other words, it relates the change in the rate of wage inflation to the unemployment rate. At the time, cognoscenti were saying that Friedman had moved the Phillips Curve one derivative.

Some comments.

1. The Act I Phillips Curve works better over the 27-year period (Acts III and IV) that Krugman covers. Within the sample period, in 9 out of the 10 years when unemployment is near the bottom of its range (less than 5 percent), wage inflation is near the top of its range (3.5 percent or higher). In all three high-unemployment years, wage inflation is less than 2.5 percent.

2. Although the rate-of-change in wage inflation is also correlated with the unemployment rate, the relationship is not as impressive. In the late 1990s, we had the lowest unemployment rate, but wage inflation actually declined (admittedly by only a small amount). More troubling is the fact that the very high rate of unemployment in recent years produced a decline in wage inflation hardly larger than that of the much milder previous recessions.

3. The overall variation in wage inflation over the 27 years is remarkably low. It ranges from 1.5 percent to 4 percent. When there is this little variation to explain, the actual magnitude of the effect of variations in unemployment on inflation is going to be pretty small. See the post by Menzie Chinn. If you do not have any data points that include high inflation, then you cannot use the Phillips Curve to explain high inflation. Chinn argues that the relationship is nonlinear. I would say that we do not know that there exists a nonlinear relationship. What we know is that we observe a relationship that, if linear, has a shallow slope. The most we can say is that if there is a steep slope somewhere, then there is a nonlinear relationship.

4. If you had given a macroeconomist only the information that wage inflation varied between 1.5 percent and 4 percent, that macroeconomist would never have believed that such a time period included the worst unemployment performance since the Great Depression. In terms of wage inflation, the last five years look like a continuation of the Great Moderation.

Some larger points concerning market monetarism, paleo-Keynesianism, and the microfoundations debate:

5. Concerning Scott’s view of things, I have said this before: Arithmetically, nominal GDP growth equals real GDP growth plus growth in unit labor costs plus the change in the price markup. If you keep the price markup constant and hold productivity growth constant, then nominal GDP growth equals real GDP growth plus wage growth. So it is nearly an arithmetic certainty that when nominal GDP grows more slowly than wages, then real GDP declines. But to me, this says nothing about a causal relationship. You could just as easily say that a decline in real GDP causes nominal GDP to grow more slowly than wages. What you have are three endogenous variables.

Scott insists on treating nominal GDP growth as the exogenous variable controlled by the central bank. To me, that is too much of a stretch. I am not even sure that the central bank can control any of the important interest rates in the economy, much less the growth rate of nominal GDP. Yes, if they print gobs and gobs of money, then inflation will be high and variable, and so will nominal GDP growth. But otherwise, I am skeptical.

6. I view paleo-Keynesianism as being hostile to Act III macro. I share this hostility. However, right now, you have saltwater economists saying, “Freshwater economists reduce macroeconomics to a single representative agent with flexible prices solving stochastic calculus problems. Hah-hah. That is really STOOpid.”

The way I look at it, the Act III New Keynesians reduced macroeconomics to a single representative agent with sticky prices solving stochastic calculus problems. They should not be so proud of themselves.

Paul Krugman calls Act III macro a wrong turn. (Pointer from Mark Thoma.) I would not be so kind. I also would not be as kind as he is to the MIT macroeconomists who emerged in that era.

You cannot just blame Lucas and Prescott for turning macro into a useless exercise in mathematical…er…self-abuse. You have to blame Fischer and Blanchard, too. Personally, I blame them even more.

Having said all that, I do not share Krugman’s paleo-Keynesianism. Just because the Lucas critique was overblown does not mean that other critiques are not valid. I have developed other doubts about the Act I model, and these lead me to believe that PSST is at least as plausible a starting point for thinking about macro.

Antonio Fatas Starts a Discussion

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He wrote about what he sees as four missing ingredients in mainstream macroeconomics. Let me focus on his last two:

There is plenty of evidence that price rigidities are important and they help us understand some of the features of the business cycle. But there must be more than that. There are other frictions in the real economy that produce a slow adjustment and are responsible for the persistence of business cycles.

… The notion that co-ordination across economic agents matters to explain the dynamics of business cycles receives very limited attention in academic research.

Robert Waldmann adds,

I think the problem is that with coordination failures, multiple equilibria are possible. Not just two or two hundred either, but a large infinite number. There is no theory which tells us how likely different equilibria are. Worse, policy shifts can cause the economy to jump from one equilibrium to another in unpredictable ways.

This does not strike me as an argument against the validity of models of coordination failure. In fact recessions are hard to predict and, well, look like panics. The problem is that models which say that macroeconomists will not be able to predict well are not popular.

Pointer from Mark Thoma.

When I wrote one of my PSST papers, Peter Howitt’s response put it in the coordination failure literature. In fact, I think there is a (possibly slight) difference. “Coordination failure” sounds to me as if there is a great equilibrium sitting there, and people just cannot find it. I think that the patterns of sustainable specialization and trade need to be discovered, through trial and error.

I believe that even if there were no frictions impeding coordination, as long as entrepreneurs have to test business models without knowing whether they will work, there will be business models that fail and unemployment can result. However, this is a weird hypothetical, since there is obviously no such thing as an economy with frictionless coordination.

So my view of what macro needs would include coordination failure of a variety of types, as well as trial-and-error learning. In my opinion, the resistance to this comes from various sources:

1. As Waldmann says, you have multiple equilibria. In fact, you never get to any one equilibrium, so that the very notion of equilibrium as a core modeling element loses salience. That creates a ton of discomfort.

2. The system is no longer hydraulic, in which more X (fiscal stimulus, monetary growth) leads to proportional increases in Y (GDP, inflation, employment). For many macroeconomists, the whole point of modeling is to come up with implications for fiscal and monetary policy. The idea that your model may not lead to a cure for business cycle makes the effort seem pointless, at least in compared with Keynesian can-do thinking.

3, It is inconsistent with popular modeling simplifications, such as the “representative agent.” For the purpose of publishing papers in journals, economists like to gravitate toward standard models. It is much easier to get published if you do a variation on a standard model than if all the people working on an idea are just groping around in different ways. I think that the coordination-failure approach to macro involves this disparate groping, and thus it suffers from….a co-ordination failure, if you will. The DSGE folks can co-ordinate. The rest of us can’t. So even though the DSGE stuff is a blind alley we have better ideas, when it comes to the journal process, we lose.

Macroeconomic Changes

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From an article bySerena Ng and Jonathan H. Wright (gated)

There has been a secular increase in the share of services in consumption from an average of 50 percent before 1983 to 65 percent after 2007, at the expense of nondurables (from 35 percent to 22 percent). Labor share in the nonfarm sector has fallen, as has the share of manufacturing employment. The civilian labor force participation rate stands at 63.5 percent in 2013, much below the peak of 67.2 percent in 1999. This is in spite of the female participation rate rising from under 35 percent in 1945 to over 60 percent in 2001, as the male participation rate has been falling since 1945. The economy has experienced increase openness; international trade and financial linkages with the rest of the world have strengthened, with the volume of imports plus exports rising from 12 percent of GDP before 183 to 27 percent post-2007. Meanwhile, not only have households’ and firms’ indebtedness increased, so has foreign indebtedness. For example, the household debt-to-asset ratio rose from under 0.75 in the 1950s to over 1.5 in 2000 and has since increased further. Net external assets relative to GDP have also risen from 0.82 in the 1970s to 2.4 when the sample is extended to 2007.

Keep in mind that the conceit of macroeconometrics is that each quarter is an independent observation, and that by controlling for a few variables one can make, say, 1982 Q1, equivalent to 2009 Q3, except for key policy drivers. If you cannot buy that (and of course you cannot), then I believe that you have reasons to be skeptical of any purported estimates of multipliers.

Hal Varian on Big Data

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The self-recommending paper is here.

When confronted with a prediction problem of this sort an economist would think immediately of a linear or logistic regression. However, there may be better choices, particularly if a lot of data is available. These include nonlinear methods such as 1) neural nets, 2) support vector machines, 3) classifi cation and regression trees, 4) random forests, and 5) penalized regression such as lasso, lars, and elastic nets.

In one of his examples, he redoes the Boston Fed study that showed that race was a factor in mortgage declines, and using the classification tree method he finds that a tree that omits race as a variable fits the data just as well as a tree that includes race, which implies that race was not an important factor.

Thanks to Mark Thoma for the pointer.

P(A|B) != P(B|A)

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Timothy Taylor writes,

those in the top 1% are almost surely paying the top marginal tax rate of about 40% on the top dollar earned. But when all the income taxed at a lower marginal rate is included, together with exemptions, deductions, and credits, this group pays an average of 20.1% of their income in individual income tax.

…The top 1% pays 39% of all income taxes and 24.2% of all federal taxes.

Assume you are in the top 1 percent. For any particular dollar of your income, there is 20.1 percent chance that it winds up with the government. However, for any particular dollar (not necessarily yours) that winds up with the government, there is a 39 percent chance that it came from your income.

Hydraulic Modeling

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[Irving] Fisher designed a hydrostatic machine to illustrate the economic “‘exchanges’ of a great city” that revealed the ways that the values of individual goods were related to one another. When Fisher adjusted one of the levers, water flowed to affect the general price level of the range of goods. The device resembled a modern-day foosball table but with various cisterns of different shapes and heights representing individual consumers and producers….A series of levers along the side of the machine altered the flow of water, thus changing the price level not only for an individual but throughout the entire economy. The machine revealed the way in which prices, supply, and consumer demand interrelated. For example, if the price of a good fell (and the level of water rose), more consumers would purchase it, and a new equilibrium would emerge.

The quote is from Fortune Tellers, a historical work by Walter A. Friedman that I received as a review copy. He tries to recover the era of economic forecasting between 1900 and 1940, before the computer and before Keynesian economics.

The graduate/undergraduate dichotomy

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Nick Rowe writes,

What should the government do, if there is an increased desire to save, and the central bank is unable or unwilling to cut real interest rates enough to offset it? The answer is that the government should cut the growth rate of government spending, to shift the IS curve left, which raises the natural rate of interest (i.e. prevents it falling), because the IS curve slopes up when we have the growth rate of transitory income on the axis…

Fiscal policy in Old and New Keynesian models is even more different than John Cochrane thinks it is. And understanding why is hard.

Read the whole thing. It is graduate-school macro, which is harder than undergraduate macro.

I will just toss in a wrinkle, which is that in these sorts of models, sometimes the way to cut the growth rate of something is to increase its level immediately. So “cutting the growth rate of government spending” can mean immediately jumping to a high rate of government spending, from which you then have a slower growth rate.

There are various dichotomies in macro. The classical dichotomy separates nominal from real. The money supply only affects nominal variables (the price level) while leaving real variables (real wages, real GDP) unaffected. The crude Keynesian dichotomy is between prices and quantities. Instead of intersecting supply and demand curves, you have quantities affecting quantities. Spending creates jobs, and jobs create spending. Prices adjust to wages, and wages adjust to prices, but neither adjusts to employment or output.

Another dichotomy is between undergraduate and graduate macro. In undergraduate macro, fiscal policy works the way old Keynesian intuition says it works–by injecting spending into the economy. In graduate macro, fiscal policy works in these weird ways of twisting the path of desired consumption.

In communicating with other academics, a Keynesian economist will manipulate these dynamic optimization equations and derive a result that says that “fiscal policy works.” But when the economist communicates with undergraduates and other ordinary mortals, they hear a completely different story–basically Old Keynesian.

For the record, I think both stories have serious problems. The problem with the Old Keynesian story is that it rules out by assumption the operation of the adjustment mechanisms that we ordinarily take for granted, in which prices respond to excess supply and demand, and resources shift in response to profits and losses. However, I will still respect you in the morning if you say you are an Old Keynesian who believes that those adjustment mechanisms operate only very slowly in the real world. You can get from there to my PSST view by simply adding the proposition that throwing more M or G at the economy does nothing to speed up this adjustment process.

I have less respect for New Keynesians. (1) Although in a charitable mood I can try to pass a Turing test as a defender of the need for “microfoundations,” in my heart of hearts I believe that these representative-agent, dynamic optimization models are a useless exercise in mathematical masturbation. (2) In policy discussions, New Keynesians seem to gloss over how their models work, wave their hands, and deliver that Old-time Keynesian religion, hoping that nobody will call them out on it. Unfortunately for them, John Cochrane and Nick Rowe are around to try to keep them honest.

You should also read Brad DeLong and Paul Krugman on this topic. My sense is that they regard New Keynesians as useful idiots. But I think that they actually prefer something closer to Old Keynesianism. I would if I were them.

Social Heterogeneity in Real Wages

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From my latest essay.

for middle- and upper-income parents, it is a matter of taste if one chooses to spend a substantial sum to send a child to an elite preschool, or to live in a neighborhood with an elite public school, or to send a child to an elite college. Given the child’s ability, such schooling decisions make relatively little difference at the margin.

The point of the essay is that long-term calculations of “the” real wage assume homogeneity of tastes.