The Great Ricardian Equivalence Throwdown!

Y'all know I cannot resist wading into a good macro throwdown.

First, a summary of the action!!

This week's econ-blogosphere mayhem started when Paul Krugman wrote a post about the idea of Ricardian Equivalence (the idea that the timing of taxes doesn't matter), and why it doesn't imply that fiscal stimulus can't work. As an example of someone who does think that Ricardian Equivalence makes stimulus a non-starter, Krugman cited some remarks by uber-macroeconomist Robert Lucas:

But, if we do build the bridge by taking tax money away from somebody else, and using that to pay the bridge builder — the guys who work on the bridge — then it’s just a wash. It has no first-starter effect. You apply a multiplier to the bridge builders, then you’ve got to apply the same multiplier with a minus sign to the people you taxed to build the bridge. And then taxing them later isn’t going to help, we know that.

Krugman's argument: Ricardian Equivalence says that the timing of taxes can't matter for the economy, not that the level of government spending can't matter.

Mark Thoma concurred: Ricardian Equivalence does not say that stimulus can't work, and Ricardian Equivalence is wrong anyway. But if it were right, it would only be an argument against tax-rebate stimulus, not against government-expenditure stimulus.

Then Krugman came under fire from David Andolfatto, who says that Lucas's statement was obviously not talking about Ricardian equivalence, and, hence, Krugman must not understand what Ricardian Equivalence is. Steve Williamson takes a somewhat less harsh line, saying that Krugman must not understand what Lucas was trying to say.

Krugman fired back, as did Andolfatto and Williamson. Much fun was had by all. I think I'm going to dub Andolfatto and Williamson the "Krugman-Teasing Brigade of St. Louis."

Update: Andolfatto has a new post on toy models that would get you dY/dG=0 (i.e., govt. spending doesn't affect output, i.e. Lucas' claim). It's a good post, but the toy models don't include prices, which are essential to many of the arguments for fiscal stimulus. Krugman challenges Andolfatto to explain the crux of his arguments without math.

Update: John Cochrane responds to Krugman, criticizing an example that Krugman used in his initial post. Along the way, Cochrane states that Ricardian Equivalence, by itself, implies that stimulus is ineffective. Mark Thoma convincingly refutes that latter statement, citing Robert Barro, the actual inventor of Ricardian Equivalence. DeLong argues against Cochrane's criticism of Krugman's example (and again here). Krugman also fires back at Cochrane. Karl Smith chimes in on the side of stimulus.

* * *

Now on to my (partially mistaken) contribution to the debate!

So allow me to wade in here. First of all, though it might not be clear from the heated exchange, Krugman, Andolfatto, Thoma, and Williamson all actually agree on the most important point! Ricardian Equivalence is about the timing of taxes, not about the effect of government spending. Hence, Ricardian Equivalence doesn't say whether or not government spending helps or hurts the economy. Everyone agrees about that!

Actually, this argument is about the second-order issue of what Bob Lucas was trying to say. So let me talk about that.

Lucas is restating Say's Law (Update: Actually, no! I made a mistake here; see below.). Say's Law says, basically, exactly what Lucas says: If you take money from Person A and give it to Person B, then total output (GDP) will be unchanged. This The idea that the effect of government spending is exactly canceled out by the effect of taxes is a very common argument for why stimulus can't work. Lucas is saying that A) Say's Law holds government spending cannot change output, and that B) you can't get around Say's Law that principle by taxing people in the future instead of today, because people are forward-looking and have rational expectations, so that the expectation of future taxation has the same effect as taxation in the present. That last part - the idea that expected future taxes have the same effect as present taxes - is Ricardian Equivalence.

So, Lucas is saying:
(Say's Law in the static case) + (Ricardian Equivalence) = (Say's Law in the dynamic case)
(dY/dG = 0 in the static case) + (Ricardian Equivalence) = (dY/dG = 0 in the dynamic case)

Now, it seems to me that IF you believe that Say's Law dY/dG = 0 holds in the static case (i.e., for tax-financed stimulus), and IF you believe in Ricardian Equivalence, it's reasonable to conclude that  Say's Law dY/dG = 0  holds for deficit-financed stimulus as well. The simplest interpretation of Lucas' statements is that he believes both.

Krugman thinks that Lucas thinks that Ricardian Equivalence implies that Say's Law dY/dG = 0 holds. Does Lucas think that? I don't think we can know, just from those short remarks.

But actually, I know of a pretty simple way to modify the Ricardian Equivalence Theorem so that it does imply Say's Law  dY/dG = 0. All you have to do is assume that government spending, G, is handed out to people as lump-sum transfers (either today or in the future), instead of used to make purchases. With this modification, G just becomes negative taxation. And since taxes in the Ricardian Equivalence model are non-distortionary, government spending would be non-distortionary too. The level of G would not affect output.

It may be that Lucas had such a model in mind. I often encounter the assumption, among economists and non-economists alike, that government spending consists purely of transfers. It is an explicit assumption in many models. It is not an assumption that, in my opinion, makes a lot of sense. But if Lucas was working with that assumption, then he could in fact start with Ricardian Equivalence and end up with Say's Law dY/dG = 0:

(Ricardian Equivalence) + (All govt. spending is nondistortionary transfers) = (Say's Law in the dynamic case)

(Ricardian Equivalence) + (All govt. spending is nondistortionary transfers) = (dY/dG = 0 in the dynamic case)

And Krugman would thus have read Lucas 100% correctly.

It's possible, though, that Krugman did read Lucas wrong, and that Lucas believes in the static version of Say's Law the ineffectiveness of government spending for other reasons entirely. In that case, Krugman should simply do a follow-up post called "Oh, and Say's Law is wrong too", because Say's Law is almost certainly wrong. (Even Say thought Say's Law was wrong!) "Lucas is wrong even if Ricardian Equivalence is right". Even if Krugman overestimated the degree to which Lucas was mentally extending the Ricardian Equivalence model, it's still true that Lucas' belief in Say's Law the ineffectiveness of government spending isn't something most macroeconomists would agree with.

I also think that Krugman's initial post was meant to say "Anyone who reads Lucas' remarks and comes away thinking that Ricardian Equivalence implies  Say's Law the ineffectiveness of government spending  is wrong." Which would also be a good point.

So basically, I score this throwdown: Krugman 2, Krugman-Teasing Brigade of St. Louis 1. On one hand, Ricardian Equivalence definitely does not imply Say's Law Lucas' claim, except in a special and unrealistic case (e.g. where all spending is just transfers). So nobody should try to overuse Ricardian Equivalence in this way! On the other hand, Krugman may or may not have overinterpreted the degree to which Lucas' belief in  Say's Law the ineffectiveness of government spending actually springs from his belief in Ricardian Equivalence. Who can know. But it's not a big deal. Because the big, important point is that, Ricardian Equivalence or no, Say's Law is just not right (Update: and from Say's Law not being right, it's only a short hop to what Lucas said being not right either), and Lucas was therefore making a very unorthodox and controversial claim.


Update: Smacked down by Brad DeLong! DeLong takes issue with two aspects of my post. The first is that I have mis-stated Say's Law:

I think Noah Smith is wrong here. Say's Law does not say that fiscal policy cannot affect spending but monetary policy can. Say's Law says that neither monetary nor fiscal policy can affect the level of spending because supply creates demand...

I agree that Lucas is wrong. But to say "Lucas believes in Say's Law" is, I think, not quite the right way to put it, for Lucas's statements are not consistent with Say's Law. 

Brad is correct. I stupidly and lazily copied the Lucas quote to my post and then considered it in isolation, forgetting that Lucas had said elsewhere in his remarks that monetary policy could be effective (a statement that is not consistent with Say's Law). So when I said "Say's Law" in the post above, I was completely wrong. Commenter TGGP actually pointed this out as well. Anyway, doh.

Brad also doesn't like that I am making claims about what Lucas "believes":

Noah Smith uses the phrase "X believes" as shorthand for "X's statements are consistent with a model in which". I think that is a misleading way to think about it... 

Now there is a sense in which this is a totally fruitless exercise: there is no point in trying to set out what the coherent model underlying somebody's thinking is when in fact there is no coherent model underlying their thinking.

I agree that we can't really know what model of the economy Lucas actually believes, or what probability weights he puts on various models. Or if he even had any formal model in mind at all when he made his remarks. I might be being too generous to Lucas - he might have just been tossing off incoherent statements without thinking of their implications, as DeLong says. Or I might be unfairly putting words in Lucas' mouth - he might actually have an underlying model in mind that is much more complex and has much more believable assumptions than the toy models Brad and I postulate (if so, Lucas should publish it).

It would have been more accurate for me to have said: "Lucas states that the level and type of government spending does not affect output, all other variables being equal. It is possible that Lucas arrived at this conclusion by using a slight modification of the assumptions that lead to the Ricardian Equivalence result, i.e. that Lucas was thinking about Ricardian Equivalence and simply assumed that government spending = transfers, and concluded that spending doesn't affect output. It is also possible that Lucas had some other model in mind, and if that is the case, then we just don't know what it is. Or it's possible that Lucas had no model in mind at all. But the statement that government spending can't affect output is not true in most models,  so whether Lucas' statement was motivated by a modified Barro-Ricardo type model is a bit of a moot point."


Update 2: Krugman also catches my mistake. He also describes Lucas' argument as "Ricardianoid", which I think is a good term for a model that starts with the Barro-Ricardo model and adds the assumption that government spending is pure transfer.

The liberty of local bullies

I have not been surprised by any of the quotes that have recently come to light from Ron Paul's racist newsletters. I grew up in Texas, remember, and I know from experience that if you talk to a hardcore Paul supporter for a reasonable length of time, these sorts of ideas are more likely than not to come up.

So does this mean that Ron Paul's libertarianism is merely a thin veneer covering a bedrock of tribalist white-supremacist paleoconservatism? Well, no, I don't think so. Sure, the tribalist white-supremacist paleoconservatism is there. I just don't think it's incompatible with libertarianism.

I have often remarked in the past how libertarianism - at least, its modern American manifestation - is not really about increasing liberty or freedom as an average person would define those terms. An ideal libertarian society would leave the vast majority of people feeling profoundly constrained in many ways. This is because the freedom of the individual can be curtailed not only by the government, but by a large variety of intermediate powers like work bosses, neighborhood associations, self-organized ethnic movements, organized religions, tough violent men, or social conventions. In a society such as ours, where the government maintains a nominal monopoly on the use of physical violence, there is plenty of room for people to be oppressed by such intermediate powers, whom I call "local bullies."

The modern American libertarian ideology does not deal with the issue of local bullies. In the world envisioned by Nozick, Hayek, Rand, and other foundational thinkers of the movement, there are only two levels to society - the government (the "big bully") and the individual. If your freedom is not being taken away by the biggest bully that exists, your freedom is not being taken away at all.

In a perfect libertarian world, it is therefore possible for rich people to buy all the beaches and charge admission fees to whomever they want (or simply ban anyone they choose). In a libertarian world, a self-organized cartel of white people can, under certain conditions, get together and effectively prohibit black people from being able to go out to dinner in their own city. In a libertarian world, a corporate boss can use the threat of unemployment to force you into accepting unsafe working conditions. In other words, the local bullies are free to revoke the freedoms of individuals, using methods more subtle than overt violent coercion.

Such a world wouldn't feel incredibly free to the people in it. Sure, you could get together with friends and pool your money to buy a little patch of beach. Sure, you could move to a less racist city. Sure, you could quit and find another job. But doing any of these things requires paying large transaction costs. As a result you would feel much less free.

Now, the founders of libertarianism - Nozick et. al. - obviously understood the principle that freedoms are often mutually exclusive - that my freedom to punch you in the face curtails quite a number of your freedoms. For this reason, they endorsed "minarchy," or a government whose only role is to protect people from violence and protect property rights. But they didn't extend the principle to covertly violent, semi-violent, or nonviolent forms of coercion.

Not surprisingly, this gigantic loophole has made modern American libertarianism the favorite philosophy of a vast array of local bullies, who want to keep the big bully (government) off their backs so they can bully to their hearts' content. The curtailment of government legitimacy, in the name of "liberty," allows abusive bosses to abuse workers, racists to curtail opportunities for minorities, polluters to pollute without cost, religious groups to make religious minorities feel excluded, etc. In theory, libertarianism is about the freedom of the individual, but in practice it is often about the freedom of local bullies to bully. It's a "don't tattle to the teacher" ideology.

Therefore I see no real conflict between Ron Paul's libertarianism and his support for the agenda of racists. It's just part and parcel of the whole movement. Not necessarily the movement as it was conceived, but the movement as it in fact exists.

Wages and the Great Vacation: Casey Mulligan responds

Two posts back, I explained why the "Great Vacation" idea doesn't pass the smell test. If U.S. unemployment had been caused by a negative shock to labor supply, we should have expected to see an increase in real wages.

Casey Mulligan, one of the leading proponents of the Great Vacation story, responded on his blog:

A number of bloggers have recently discovered real wages as a labor market indicator. They are at least 3 years late to the party. 

Three years ago I blogged about the effect of labor supply on real wages. 

I noted how real wages had risen since 2007, and predicted that they would begin to decline in 2010. 

I have continued to update this work, eg here, and here. 

The fact is that the real wage time series fits my recession narrative very well.

Well, in response to that, let's look at the numbers. Here, courtesy of FRED, is a graph of real compensation per hour in the nonfarm business sector:

A negative shock to labor supply should be associated with a spike in real compensation per hour. Looking at this graph, do you see such a spike? I do not. In fact, if I were to tell you that there had been a Great Vacation, and asked you to point out its beginning on that graph (without showing you the gray bars), you would probably say that it began in 2003, or maybe 2006 or 2009. You would not predict that a supply-driven recession began in 2008, when our real recession actually began.

Yes, it is true that real wages rebounded fairly rapidly from the trough to which they fell at the beginning of the Great Recession. And it is true that they climbed slightly higher after that, in 2009, reaching a peak about 2% higher than their 2006 peak. So Mulligan's statement that real wages rose during the Great Recession is correct.

However, note the size of the rise. There is no discernible increase in the rate of growth of real wages during the Great Recession. The wage growth to which Mulligan refers was slower by far, for example, than the growth that occurred between 2000 and 2004. If the Great Recession were caused by a massive negative labor supply shock, we would expect to see wages accelerate as employment fell. They did not. And the sharp downward spike in real wages in 2008 is especially hard to reconcile with a Great Vacation story.

I maintain my original case that the wage data shows no sign of a Great Vacation. If a Great Vacation in fact occurred, it had to have been a much more complicated sort of thing than the kind of negative labor supply shock that is taught in Econ 101.

A satisfactory philosophy of ignorance (John Cochrane edition)

"I feel a responsibility as a scientist who knows the great value of a satisfactory philosophy of ignorance...I feel a responsibility...to teach that doubt is not to be feared."

- Richard Feynman

A few posts back, I blogged about a Hoover Institute panel organized by John Taylor, in which eminent macroeconomists were invited to give their thoughts on how to restore America to robust growth. Now, via David Glasner, I have found a transcript of John Cochrane's remarks at the panel. Given Cochrane's polemic tone in past writings, my hopes were not exactly high. But I went ahead and read the whole thing, and what I found left me (mostly) pleasantly surprised. Cochrane spends much of his time talking about how macroeconomists really don't understand that much about the economy:

Why are we stagnating? I don’t know. I don’t think anyone knows, really...Nothing on the conventional macro policy agenda reflects a clue why we’re stagnating... 

This conference, and our fellow economists, are chock full of brilliant new ideas both
macro and micro. But how do we apply new ideas? Here I think we economists are often a bit arrogant. The step from “wow my last paper is cool” to “the government should spend a trillion dollars on my idea” seems to take about 15 minutes... 

Compare the scientific evidence on fiscal stimulus to that on global warming . Even if you’re a skeptic, compared to global warming, our evidence for stimulus ‐‐ including coherent theory and decisive empirical work ‐‐ is on the level of “hey, it’s pretty hot outside.”... 

There are new ideas and great new ideas. But there are also bad new ideas, lots of warmed over bad old ideas, and good ideas that happen to be wrong. We don’t know which is which. If we apply anything like the standards we would demand of anyone else’s trillion‐dollar government policy to our new ideas, the result for policy, now, must again be, stick with what works and the stuff we know is broken and get out of the way. 

But keep working on those new ideas!

These quotes, in my opinion, are spot on. If there's one point I've consistently tried to push since I started writing about macro on this blog, it's that we don't really know that much about how business cycles work. Sure, we are reasonably sure of a few things, like that most recessions, and the biggest recessions, are driven by demand shocks (as is high unemployment). And it seems that having the government spend money boosts GDP growth during recessions. But in general, we are just very ignorant. We don't have a really good (i.e., quantitatively predictive) model of how aggregate demand works, or why stimulus has an effect.

Given this ignorance, the appearance of precision and "sciency-ness" offered by modern business-cycle models seems pernicious to me. It biases the field toward making minor modifications of the existing paradigm (Olivier Blanchard's "haikus") rather than exploring blue-sky ideas that might lead to real leaps in our understanding. I can't offer a ready alternative to the DSGE paradigm (maybe someday I will), but I think that in the absence of something that works, the best alternative is to adopt a "satisfactory philosophy of ignorance."

So I like what Cochrane is saying about our ignorance. And I think there is a powerful case to be made for policy inactivity - the idea of "first do no harm." If you are a doctor and your patient is in critical condition, but you don't know how to save him, you don't just pump him full of every drug you have. If I were an opponent of fiscal stimulus, that is exactly the argument I would make - that the burden of proof is on the proponents of stimulus, and that the evidence is too muddled to risk making the situation worse. 

Unfortunately, stimulus opponents typically make far bolder claims, like "stimulus can't possibly work." And in doing so they throw away their natural advantage, because instead of a "satisfactory philosophy of ignorance," they reach for a false certainty and end up overstating their claims.

This is also where John Cochrane, in my opinion, stumbles a bit. Even as he points out how ignorant macroeconomists are, he goes ahead and offers his own positive theory of the recession:

So what if this really is not a “macro” problem? What if this is Lee Ohanian’s 1937 – not about money, short term interest rates, taxes, inadequately stimulating (!) deficits, but a disease of tax rates, social programs that pay people not to work, and a “war on business.” Perhaps this is the beginning of eurosclerosis. (See Bob Lucas’s brilliant Millman lecture for a chilling exposition of this view).

Yes, Cochrane says "perhaps" and "what if." But it certainly seems as if he leans toward the Ohanian view. The problem is, this view is pretty easily debunked by a casual reading of history. Tax rates have not gone up since 2007, and social programs are not currently more generous than in the past. There is much we don't understand about the true causes of recessions, but at least we understand that much! 

But then Cochrane comes back and says this:

Our (microeconomic) garden is full of (policy) weeds. Yes, it was full of weeds before, but at least we know that pulling the weeds helps. Or maybe not. (emphasis mine)

This is great! Not only does Cochrane move away from Ohanian-land and back toward the "first do no harm" critique of stabilization policy, but he admits that even that might not be right!

So basically, even though it includes a number of substantive points with which I'd argue, I really, really like this Cochrane talk. Now there's a sentence I didn't expect to see myself writing when I first followed the link!

It has always been my opinion that the neoclassical revolution hit its high point with the Lucas Critique. It was a great thing to expose the inadequacy of the macro models then in use. But when the neoclassicals went ahead and replaced those models with RBC and Rational Expectations, I feel like the revolution really overreached. The inability of RBC (or DSGE in general) to explain our current economic woes has led some neoclassical-minded folks to reach for Ohanian-style explanations (it's the socialists' fault!). Instead, I think that they should go back to where Lucas started, and embrace a "satisfactory philosophy of ignorance." Even as someone who is very dubious of the neoclassical worldview, that is a perspective with which I would heartily agree.

I shall now debunk the "Great Vacation" in one sentence.

"I refute it thus!"
- Bishop Berkeley

Chad Stone explains the "Great Vacation" hypothesis:

The “Great Vacation” narrative holds that unemployment insurance (UI) benefits...have dissuaded millions of unemployed workers from taking a job.  If...jobless workers would get off their duff (or if we would give them a good swift kick there), unemployment would plummet.

Some "neoclassical" economists (e.g. Casey Mulligan) have adopted the "Great Vacation" as their favored explanation for the recession we are in. The story has also made its way into the political discourse, where it is now a regular Republican talking point.

I shall now debunk the "Great Vacation" in a single sentence:

If the labor demand curve slopes down, then a fall in labor supply should be accompanied by an increase in wages; since wages fell or stagnated in the Great Recession and have grown only slowly ever since, unemployment is not being caused by a decrease in labor supply.

OK, OK, I used a semicolon. Sue me.

Really, this is incredibly simple. Our intuition says that when a commodity becomes more scarce, the price goes up. Duh, right? Labor is a commodity. If people suddenly decide to take a vacation - whether because of a spike in laziness or an increase in unemployment insurance - employers will raise wages in order to keep some (though not all) of those workers at their desks.

This is just a way of saying that the demand curve for labor slopes down. If the demand curve slopes up, then a negative shock to labor supply (a Great Vacation) will make wages fall (as we observe in reality). That would make labor a Giffen good. It would mean that a rise in wages makes companies want to hire more workers. It would mean, among other things, that union power, by increasing wages, also increases employment. If Casey Mulligan and other Great Vacation proponents want to argue that labor demand curves slope up, well, be my guest, but the burden of proof is on them, and I doubt they will like the implications of the result.

Look, if price goes down and quantity goes down, chances are that there has been a leftward shift in the demand curve, not the supply curve. That is Econ 101 common sense. It's also a specific instance of a general principle of science: when an external influence acts on a stable system, the system will react so as to partially counteract the external influence. In physics this manifests as Lenz's Law, in psychology as opponent-process theory. If you want to see what kind of shock happened to a system, look at how the system reacted.

We are not on a Great Vacation.

Delusions of helplessness, monetarist edition

I'm very sorry to do this, but today I must hit Scott Sumner with the Bat Boy pic. Bat Boy is deployed whenever an econ blogger makes a claim that is truly batty. Which, to be honest, we do fairly frequently, since we have no editors and we often write while under the influence of various (legal) drugs such as iced tea, Ambien, and YouTube.

But anyway, via Brad DeLong, I find Scott Sumner making this batty claim:

Keynesian economists have never been able to accept my assertion that the fiscal multiplier is roughly zero because the Fed steers the (nominal) economy.

Translated roughly from Monetarese into English, this means: "If Congress tries to boost output by spending money, the Fed will counteract this effort by enacting tighter monetary policy. Thus, stimulus can never work."

Why is this a batty claim? Well, to see why, we must first identify the assumptions that would have to be true for the claim to hold. These are:

Assumption 1: The Fed can control the path of nominal spending (NGDP).

Assumption 2: The Fed does choose to control the path of nominal spending in a way that will cancel out any stimulus.

I admit to being dubious of the first assumption. I think that the Fed probably observes the factors that affect future nominal spending only with a lag, and that there is also a substantial unpredictable component of the effect of the Fed's actions, making it difficult for the Fed to steer nominal spending with precision. But this is not why I think that Sumner's claim is batty. Assumption 1 - that NGDP targeting could work - is something that is not obviously false. It's also something that Scott Sumner and many other smart bloggers say all the time.

The batty part is Assumption 2. This is an assumption about the Fed's "reaction function" - the way that the Fed actually does respond to changes in the economy. For stimulus to be ineffective, the reaction function has to cancel out any and all output changes that result from fiscal policy changes.

What kind of Fed policy would do this? Well, the Fed could target the growth rate of NGDP. Suppose that the Fed decides that NGDP should grow at 4% a year. Then a fiscal stimulus that tried to push NGDP growth up to 6% a year in the wake of a recession would cause the Fed to tighten (i.e. print less money), frustrating Congress and holding NGDP growth at 4%.

Alternatively, the Fed might target the level of NGDP. In this scenario, the Fed might not counteract fiscal stimulus, because stimulus after a recession might work to bring NGDP back to where the Fed wants it to be. However, in this world, the stimulus turns out to be completely unnecessary, because it's only doing what the Fed would do anyway; in the absence of stimulus, the Fed would print money and buy stuff until NGDP went back to pre-recession levels.

But now notice that there is one huge huge huge problem with either of these stories: If the Fed controls either the level or the growth rate of NGDP, where the heck did the recession come from in the first place?! If the Fed both can and does counteract shocks to the NGDP path, then recessions should never happen. In other words, if the positive demand shock of a stimulus must be canceled out by the Fed, then the negative demand shock of a recession should be canceled out as well!

But it isn't. Via DeLong, here is a graph of the recent path of nominal GDP:

As you can see, both the level and the growth rate experienced a massive swing in 2008. That swing was the Great Recession. It was not counteracted by the Fed.

So to believe Scott Sumner's claim about the powerlessness of fiscal stimulus, you must believe that the Fed can and does counteract stimulus, but either can't or chooses not to counteract recessions. Essentially, you must either believe that the Fed's powers of stabilization are severely limited (which Scott Sumner probably does not believe, given everything he writes), or that the Fed wants to torpedo the U.S. economy.

(Update/Aside: This last item deserves more explanation. It is theoretically possible that the Fed targets the NGDP growth rate, but occasionally makes mistakes, and never tries to correct its past mistakes. So when there are big recessions, the Fed simply lets them happen, and then actively prevents recoveries from returning us to our previous NGDP trend line. Since recessions are more abrupt than booms, this means the Fed is actively out to torpedo the U.S. economy. Now maybe this is true - if the Fed has a bizarre nonlinear hard-money bias that manifests more in recessions than booms, it could be true! - but it would mean that past recessions would have manifested as unit-root drops in output...in other words, a bunch of L-shaped recessions in the past. Most people think that that isn't what we've seen; that after past recessions, output has returned to trend, and that drops in output were not "frozen in" by a deranged Fed. Anyway, now back to your regularly scheduled ranting...)

That is why the claim is a bit batty. If the Fed is truly omnipotent, then we shouldn't see any recessions, or any calls for fiscal stimulus in the first place. The fact that we're even having this debate makes the "helplessness" position untenable.

Incidentally, this is not the first time I've seen Sumner make this claim. In a post on trade policy back in October, he wrote:

If the Fed follows its announced policy of inflation targeting, the contractionary effect of China’s [decision to float its currency] on world output will not be offset by any expansionary effects on the US.  

This is exactly the same idea. If the Fed both can and does control output, no (demand-side) policy other than a change in the Fed's policy rule can ever have an effect on output. It doesn't square with the very real fact of recessions.

But here's something else I've noticed - this "helplessness" perspective kind of clashes with Scott Sumner's usual line. Sumner spends a lot of time arguing that the economy would be OK if the Fed would just target NGDP. But if the Fed already effectively steers the path of nominal output - so effectively that stimulus and trade policy are ineffectual - then what is Sumner complaining about?

So anyway, I'm sorry Bat Boy had to be trotted out. I am sure it will be me making a batty claim sometime soon, and I hope someone out there cares enough to point it out. Speaking of which, I need some more iced tea...


Update: I wrote this in a comment and thought I should move it up to the main post:

Really what it comes down to is this: If you believe that the Fed can move around the NGDP path at will, it is possible to postulate a reaction function such that the Fed will always cancel out any fiscal stimulus. But to assert that such a reaction function does exist is a claim that has little or no evidence to back it up. And to assert that such a reaction function logically must exist, simply because it can, is nonsense. Hence, Bat Boy.

I'm not sure if this last, strongest, and most preposterous claim is the claim that Scott Sumner is making...it sounds like it might be. But even if it's simply an empirical claim that in practice the Fed does try to counteract stimulus, then I want to see the evidence.

Update: I may have overinterpreted Sumner's claim. If so, the Bat Boy is hereby revoked. This is important, since Bat Boy is only used when theoretical claims are made that are clearly false, and hence is not to be summoned lightly...

A hideous anti-immigrant attack

Dhammika Dharmapala is a law professor at the University of Illinois. My friend David Agrawal at UMich (one of our strongest job candidates this year) says that Professor Dharmapala is "the reason I'm an economist."

So I'm sad and disgusted to report that Professor Dharmapala was slashed in the throat yesterday, in what is pretty clearly a hate crime. Fortunately, and somewhat miraculously, Professor Dharmapala will live, and is making a faster-than-expected recovery. But that does nothing to diminish the awfulness of the attempted murder.

Here are the details:

Joshua Scaggs, 23...has been charged with attempted murder and two counts of aggravated battery, alleging he slashed the throat of Anurudha Udeni Dhammika Dharmapala, 41, of Champaign at the Illinois Terminal on Wednesday morning...

A male witness told police the men were both seated in the waiting area when one man suddenly jumped up and shouted that this was his country and attacked Dharmapala.
The attacker, later identified as Scaggs, then grabbed Dharmapala around the neck and appeared to be choking him. He then forced the victim to the floor. 

The witness intervened by pulling the attacker off Dharmapala. The witness then noticed that the attacker was holding a utility knife and the victim was bleeding. 

Ziegler said Dharmapala was waiting to take a train to Chicago. He had no information on why Scaggs may have been there. Police recovered the box cutter believed used to injure Dharmapala. He said Scaggs had another folding knife in his pocket.

So this guy Scaggs went out with a box-cutter and a folding knife, obviously intending to attack someone. He sees a random non-white guy in a train, jumps up, screams "I want my country back," and cuts the guy's throat. Bizarrely, the crime is not being prosecuted as a hate crime. If that's not a hate crime, what is?!

Hate crime or no, Scaggs will certainly rot in jail, as he deserves. But I hope I'm not alone in thinking that this kind of attack is a very bad sign for America in general. For two reasons.

First of all, as I've written before, I believe that racial animosity is wreaking havoc on this country's political process. Tribal animosity makes people paranoid that any government policy represents an attack on their group by another group. And so you hear people blaming "those lazy [insert nonwhite race here]" for the financial crisis and the recession, which reduces our ability to fight the recession with government policy. And you hear people saying that government spending is racial redistribution...so our roads and bridges and research institutions crumble and decay.

But taking a longer view, I believe that immigration - particularly from Asia - is key to our nation's economic success. In a globalized world where companies choose their locations based on access to large domestic markets, having a dense population will be important. Also, high immigrant fertility is the only reason why our country is managing to avoid the demographic disaster looming over East Asia and Europe. Finally, immigrants are a tremendous source of entrepreneurship.

So the idea that non-white immigrants are "taking America away" from whites is by far the most pernicious force in America today. This idea is slowly but steadily making itself an unwelcome fixture in our public discourse.

Now the reason I am saying this is not to make political hay, or to lay blame for this attack on anyone but the perpetrator. It is simply to point out that the murderous hate crimes of a few isolated psychos are not simply isolated and independent random events. They are warning signs of larger forces of hate lurking within our society, corrosively eating away at the foundations of our national polity.

Anyway, best wishes to Professor Dharmapala for a speedy recovery.

Hoover Institute recommends Hooverite policies

Via John Taylor, today's "dog bites man" story:

Why has the recovery been so slow? What can we do about it? Alan Greenspan, George Shultz, Ed Prescott, Steve Davis, Nick Bloom, John Cochrane, Bob Hall, Lee Ohanian, John Cogan and I recently met at the Hoover Institution at Stanford to present papers and discuss the issue with other economists and policy makers including Myron Scholes, Michael Boskin, Ron McKinnon and many others...In sum there was considerable agreement that (1) policy uncertainty was a major problem in the slow recovery, (2) short run stimulus packages were not the answer going forward, and (3) policy reforms that would normally be considered helpful in the long run would actually be very helpful right now in the short run.

Wow, shocking. The recession is Obama's fault for being a crypto-socialist, stimulus doesn't work, and the rich should get tax cuts. Who would have ever guessed that this team of mavericks would reach such a startling conclusion?

But I kid. Actually, the story of the Hoover conference is a little more interesting. It seems to have been pretty evenly split between people who simply re-asserted the standard conservative line, and people who supported either Keynesian solutions or an end to Republican obstructionism, but whose conclusions were spun in the writeup to fit the conference's (or Taylor's) preferred conservative policy line. So let's look at the specifics of what was said, as reported by Taylor.

First, George Schultz:

George Shultz led off by arguing that diagnosing the problem and thus finding a solution was extraordinarily important now, not only for the future of the United States but also for its leadership around world.

Mmm, you don't say...

Tax reform, entitlement reform, monetary reform, and K-12 education reform were at the top of [Schultz's] pro-growth policy list.

Because if we haven't diagnosed the disease, we might as well recommend that the patient drink lots of fluid and get plenty of exercise. That seems to be the idea here. Actually, I am pretty cool with that, since I like it when people admit how much we don't really know. It shouldn't be interpreted as blaming "uncertainty" or calling for austerity, though.

On to Alan Greenspan:

Alan Greenspan presented empirical evidence that policy uncertainty caused by government activism was a major problem holding back growth, and that the first priority should be to start reducing the deficit immediately; investment is being crowded out now.

Wow, empirical evidence that policy uncertainty is holding back growth? Show, us, please! Sadly, Greenspan's evidence appears to be proprietary, and only available to people who pay Greenspan Associates for the privilege of hearing that Obama's crypto-socialism is crippling the economy. Whereas the rest of us poor folks are forced to post all our evidence to the contrary online, for free. 

Nick Bloom, by contrast, actually does have some evidence. With Scott Baker and Steven Davis, he constructs a measure of policy uncertainty that matches historical events like 9/11, and then shows that this measure has spiked recently as well. That is well done! Of course, it's not certain which way the causality runs; large economic crises necessitate large policy responses, and there will probably be uncertainty as to what those responses will be. But anyway, Bloom appears to have produced by far the best available study on the role of uncertainty, and he should be applauded for this. Note: John Taylor fails to mention that, according to Bloom's measurements, the main sources of uncertainty in the current recession have been A) Republican brinksmanship over the debt ceiling, B) Europe, and C) efforts to sue Obama's health care bill out of existence...

Anyway, onward! Next up we have Ed Prescott:

Ed Prescott had the most dramatic policy proposal which he argued would cause a major boom and restore strong growth. He would simultaneously reform the tax code and entitlement programs by slashing marginal tax rates which would increase employment and productivity.

This line actually made me laugh out loud. A "dramatic policy proposal"...cut tax rates for the rich! Ed Prescott, you maverick, you.

But now I come to a presenter with a very differentparadigm...Robert Hall, whom a professor in my department once called the "greatest macroeconomist working today":

Bob Hall argued that fiscal policy was not working, and focused on alleviating the zero lower bound constraint on monetary policy. 

This phrasing makes Hall sound like an opponent of fiscal policy. But actually, the exact opposite is true! Hall is one of the most eminent "Keynesians" in the field, a big proponent of government expenditure as a way to get out of recessions. If you don't believe me, read this paper he wrote on fiscal stimulus. In fact, I was pretty surprised to see his name on the Hoover conference list, given this fact.

So why is Hall now saying that "fiscal policy 'was' not working"? Well, what he almost certainly means is that most of Obama's ARRA stimulus came not in the form of government purchases of things like infrastructure, but as tax credits and grants to the states, both of which were promptly saved rather than spent. This is a point that has been made by, among others, Paul Krugman and John Taylor. 

So what Hall actually said at the Hoover conference was almost certainly "Congress should borrow money and buy more infrastructure, but since it appears unwilling to do so, the Fed should print money and buy financial assets." In other words, pretty much the standard Keynesian line (Update: via Paul Krugman, I find out that Hall's position is that Obama's stimulus did help make the recession less severe, and that the stimulus should have been larger). As for John Taylor himself, the paper he presented at the Hoover conference was the one I discussed here, which said pretty much the same thing that Hall said - stimulus spending should have been more about spending on infrastructure, and less about handing people blocks of cash that they promptly stuck under their mattresses.

Which is a good point, but not really an argument for austerity.

Finally, there was Lee Ohanian:

Lee Ohanian showed that unemployment remained high in part because of restrictions on foreclosure proceedings which increased search unemployment by allowing people to stay in their homes for longer periods of time.

That's kind of interesting, actually.

Anyway, let's sum up. What we have here appears to be a conference to which the Hoover Institute invited A) prominent conservatives (Greenspan, Prescott, Cochrane, and Ohanian), and B) people who happened to be sitting nextdoor at Stanford (Bloom, Hall, and Taylor), with an eye to reiterating and affirming standard conservative policy prescriptions: austerity, tax cuts for the rich, etc. What they got wasn't quite that, but it was close enough where the dissenting voices could be spun to sound as if they agreed with the party line. Not sure if it was someone at Hoover or just Taylor himself doing the spinning. But either way, the conference shows that even in relatively conservative circles, substantial deviations from the party line can't help but pop up. Put enough smart people in the room, and at least a couple smart things will probably end up getting said.

Update: Paul Krugman thinks John Taylor heavily spun the conference results. Taylor begs to differ. In particular, Taylor says that things were discussed at the conference that were not contained in prior research by the presenters. That is, of course, usually the case at conferences; I am looking forward to seeing the discussion published.

I do have one quibble with Taylor, btw. In his new post, he writes:

Krugman claims that my summary mischaracterized the presentation of my Stanford colleague Bob Hall...As part of his presentation Bob said that now and going forward we should assume “no chance of conventional fiscal expansion; rather, possible cutbacks motivated by excessive federal debt.” That is why Bob focused his paper at the conference on monetary policy and the problem of the zero lower bound, and that was what all the discussion of his paper was about, rather than on his earlier work on the multiplier[.]

But in his original summary, Taylor wrote: "Bob Hall argued that fiscal policy was not working." (emphasis mine on both quotes)

"Not working" and "not politically feasible" are two very, very different things.

Update 2: Brad DeLong notices the same discrepancy between Taylor's posts.

Update 3: Menzie Chinn elaborates on how Nick Bloom's research supports the hypothesis that it is Republican fiscal brinkmanship, not Obama administration regulatory policy, that is causing uncertainty. Well worth a read.

What to teach intro economics students

Greg Mankiw has a good response to the walkout of his introductory econ course, which basically agrees with what I wrote. Peter Dorman, however, is not satisfied:

[T]here is a central narrative at the introductory level that has hardly changed in at least a generation, perhaps longer.  It presents a system of perfectly competitive markets composed of rational, unconnected agents as the benchmark, from which specific deviations, like externalities, behavioral anomalies, sticky prices, etc., are considered one at a time.  Most of the interesting and important work in economics is about these deviations.  If you added up all of this innovative research, you would have a composite picture that is exciting, relevant—and light years away from the introductory narrative. 

A huge gap has opened up between the introductory course and the work professional economists are actually doing.  Each departure from the narrative is considered one at a time, even though research has chipped away at all of them...Thus the introductory course still looks like a distillation of the research frontier, even though, if you put all the research results together, you would have something quite different.

First of all, I agree with Dorman completely regarding the research frontier. The whole notion of thinking of each interesting feature of the economy as a "friction," and then of considering only one or two "frictions" at a time, has been very detrimental. For one thing, it makes it hard to develop a useful model of the economy, since the actual economy contains many, many "frictions" (so many that the "frictions" together are usually more important than the "frictionless" dynamics that supposedly "underlie" them). Also, the "one friction at a time" approach makes it very difficult to generate any alternatives to the classical "core theory" of Walrasian general equilibrium. In fact, my main reason for disliking the DSGE modeling framework is that it is so unwieldy that it makes it prohibitively hard to introduce more than two "frictions."

But when it comes to intro economics - or, at least, intro macro - I don't see this dynamic in operation as much as Dorman does. Of course, I only know the classes I've taught (I've never taken an undergrad econ course). But I taught right out of Mankiw's book, and there was nothing particularly unusual about the curriculum. 

Most of what I taught was not based on a system of perfectly competitive markets. For business cycle theory, we taught the AD-AS model (beloved of montarists like Scott Sumner), the supply and demand for money, the New Keynesian Phillips curve, and the old Keynesian Cross. RBC theories were never even mentioned in the lectures (although I gave students a brief overview of them in discussion section, much to their annoyance since RBC was not on the test!). In fact, there were nothing but frictions. The theories were so different that students often asked me "How do we know which of these models to use?" (provoking a laugh from me, since that is such an excellent and often-ignored question). The focus was always on market failures, and how governments should use policy to correct them.

In sum, intro macro really doesn't look like a distillation of the research frontier. Which is a good thing.

Actually, my beef with intro macro is different. I think there is a big chunk of the research frontier that intro courses completely ignore. I'm talking, of course, about empirics. The courses I taught had nothing to say about how we know if and when a theory is right. (Note: anyone who read that sentence and immediately started typing "But ALL theories are wrong!", please think very carefully about the concept of a "domain of validity" before you start spamming the comments. Thank you.)

In natural science courses, much of the focus is on empirics. It is critical to know when a theory is a good approximation of reality and when it is not, and looking at evidence is the only way to know this. So in high school physics, you roll a ball down a ramp and measure its position at different times to see how gravity works. In chemistry you dump some silver nitrate into some potassium chloride, and you watch the silver chloride precipitate out of the solution. In biology you look at cells under a microscope.

But in introductory macroeconomics this is not done. I never once gave students a data set and said "Here, regress Y on X". There was no reason I couldn't have. OLS is easy to do, and easy to explain (simple least squares is very intuitive and can be shown with a picture). Sure, intro students aren't going to be coding DSGE models in Matlab or converging MLE routines for structural models. But doing some simple empirics would give students a feel for how economists test their theories. It would give them a hands-on feel for data. And it would allow lecturers to explain why certain statistical techniques can lead to false certainty (i.e. the Lucas Critique).

As it stands, students in introductory economics courses walk away feeling that econ theories are "received wisdom" - that a theory is just something that a smart guy dreamed up, and then concluded was right because it sort of seemed plausible (which, sad, to say, describes some econ theories all too well). And - fortunately for American society - we have somewhat of an aversion to received wisdom. We call it by the name of "bullshit." And rightly so! As Feynman said, "Science is a belief in the ignorance of experts."

So I say, if you want to give introductory economics students a better picture for what the science is really good for, teach them the part that links theory to reality. 

Harrison & Kreps 1978: The power of irrational expectations

In the past few weeks I've had discussions with several different people about why financial markets are different from normal markets. I've come to realize that there is a very deep and fundamental fact about financial markets that almost nobody in the lay public - and a good chunk of people in the finance industry itself - don't understand. And that fact just happens to have implications that also shake the foundations of modern macroeconomics.

So it's time for another addition of Papers You Should Know. Today's paper is "Speculative Behavior in a Stock Market With Heterogeneous Expectations" by J. Michael Harrison and David M. Kreps (Quarterly Journal of Economics, 1978).

Before we talk about Harrison & Kreps, we need to understand why financial markets are so weird. In a nutshell, it's this: In normal markets, people who know exactly what they are trading will often still be willing to trade. In financial markets, people who know exactly what they are trading will almost never be willing to trade. For a quick explanation of why this is true, I turn to Brad DeLong:

In a standard economic transaction, it is no mystery where the value to both sides comes from. When I buy a double espresso from Café Nefeli for $2.25, the coffee is more valuabe to me then $2.25 is...The sources of the gains from trade are obvious. 

But in finance neither side is getting useful commodities. Instead, both sides are trading away claims to a pile of money and getting claims to a different pile of money in return. So how is it that me selling this pile of cash I have to you for that pile of cash that you currently own can be a good idea for both of us? Doesn't one of the piles have to be bigger? And isn't the person who trades the bigger for the smaller pile losing?

Think about that for a second. If I offer to sell you a share of stock for $10, why would you buy it? Well, you might buy it because you want to diversify or otherwise adjust your investment portfolio (to give you, say, more risk or longer maturity). But - let's be frank - chances are you'd buy it because you think that sometime in the future it'll be worth more than $10. Right? So now ask yourself: If I (the seller) also thought it would be worth more than $10 in the future, why the heck would I sell it to you for $10???

The answer is: I wouldn't. If someone offers to sell you a stock for $10 and tells you it's going to go up up up, in general don't buy it. Because if the guy selling you the stock really believed his own rosy prediction, he'd keep the stock for himself. The only time you should buy the stock is when you have good reason to believe that you are smarter or better-informed than the guy who's selling - in other words, if you think he's a sucker. Of course, he's only selling to you because he thinks you're a sucker.

So what we see is that while normal markets consist of people making trades because they have different preferences, financial markets mainly consist of a bunch of people with the same preferences all trying to sucker each other. This fact is called the "No-Trade Theorem," and economists have known about it for a long time. 

So in 1978, J. Michael Harrison and David M. Kreps decided to write down a model of a financial market in which everyone was trying to sucker everyone else. As far as I know, this was the first model of its kind. Even though few people believe that the model describes exactly how the real world works, it has become enormously influential, because it gives an idea of what the world would have to be like in order for us to observe the enormous volumes of financial trading that we actually see happening.

Briefly, the model works like this: Different people have different beliefs about the fundamental value of an asset (i.e., how much money the asset will pay them). One person thinks it'll pay A if the economy is good and B if the economy is bad. The other person thinks it'll pay C if the economy is good and D if the economy is bad. They know that they have different beliefs, they know what other people's beliefs are, and they "agree to disagree." So they are willing to trade; each one thinks the other one is a sucker.

So what price do they trade at? Well, you might think that the most bullish investor (i.e. the person who thinks it's worth the most) would just set the price. But actually, the price ends up being even higher than the most bullish person thinks it's worth! The reason is that the asset has resale value. You can buy it, collect some money from it, and then when the economy changes, you can sell it at a profit to someone who is more bullish than you are. So the price ends up being the sum of the asset's fundamental value and its resale value. Ta-da: Speculation!

Now, like I said, nobody really thinks this is exactly how things work. For one thing, people should learn over time - as the asset pays out money, people should update their beliefs. But Harrison & Kreps is not about describing the world, it's about exploring ideas. And the basic idea they explored has become one of the most powerful in all of financial economics. Since 1978, a number of authors have taken this basic notion of investor overconfidence and tried to either make it more realistic, or find it in the data. A few prime examples include Scheinkman & Xiong (2003), who put the overconfidence idea into a modern asset pricing model, Barber & Odean (2001), who find evidence that individual investors are overconfident and trade too much, and a number of "heterogeneous prior" models that allow people to learn as they go. All of these models owe something to the pioneering work of Harrison & Kreps.

But anyway, all that is preamble. This is actually a post about macroeconomics.

You see, the No-Trade Theorem says that financial markets shouldn't have a lot of trading. But we see a LOT of trading in these markets. And Harrison & Kreps showed that those trades are best explained by irrational expectations.

So what does that say about macro? Since the late 70s, nearly all of the models used by macroeconomists have been "rational expectations" models. "Rational expectations" is the idea that people don't make systematic mistakes when predicting the future. If you think that sounds a bit silly, you're not alone, but I kid you not when I say that rational expectations absolutely dominates modern macro.

But if expectations aren't rational in financial markets, why should they be rational in the economy as a whole? The answer is that they shouldn't. This is why Thomas Sargent, who won the Nobel Prize this year and who helped develop the theory of rational expectations, calls himself a "Harrison-Kreps Keynesian." Keynes, though he is usually associated with the idea of fiscal stimulus, was a professional stock speculator, and perceived clearly the irrationality of the markets in which he participated; Sargent is merely recognizing that financial market irrationality, which was formalized by Harrison and Kreps, is a huge hint that rational expectations is not going to get the job done in macro either. 

Pioneering macroeconomists like Sargent have spent a long time hacking through the wilderness of non-rational-expectations models. It is a daunting task, since there are infinitely many ways in which people could be irrational. Rational expectations lends itself to pure logical deduction - you can kind of just sit there and figure out how people should act. But to figure out how expectations really form, you need to get your hands dirty with things like lab experiments and careful empirical work.

But we really have no choice, if we want to understand the economy as it actually exists. As David Glasner says, "expectations are fundamental"; we can't afford to treat the process of human belief formation as an afterthought. That is the insight of Harrison and Kreps, and macro as a whole needs to take it to heart.

Update: Also see this article from today's NYT on Tom Sargent and Chris Sims (this year's other Nobelist). Both believe that modeling irrationality, as it exists in the real world, is the way to go.

Update 2: I just realized that a better title for this post would have been "Why is this market different from all other markets?" Ah, the "stairway wit"...