Noahpinion

Jim Bullard chucks the Solow growth model!

2012-02-10T14:58:00.004-05:00

Sometimes I skim stuff too fast. When I saw David Andolfatto and Tyler Cowen linking to a Jim Bullard speech about wealth effects and output, I assumed that it was some sort of observation about aggregate demand. After all, wealth affects aggregate demand, so when wealth evaporates in a financial crisis, AD should fall. No surprise there.

But then, via Scott Sumner, I found out that Bullard (the president of the Federal Reserve Bank of St. Louis) is saying that wealth shocks affect long run aggregate supply!

What?!?!?!

Intuitively, this makes absolutely zero sense. Permanent negative wealth shocks lower potential output? Well, if capital is destroyed, that's true; for example, take the effect of World War 2 on Japan and Europe. All those bombs certainly lowered productive capacity (while destroying wealth). But if the financial crisis was that sort of thing, then it should raise the trend rate of growth, as we engage in "catch-up growth" to replace the destroyed capital.

Are we seeing rapid catch-up growth now? No.

So how does Bullard think this works? Is he putting forth a subtle and powerful argument that I missed by skimming? Let's see what he say in his speech:

A better interpretation of the behavior of U.S. real GDP over the last five years may be that the economy was disrupted by a permanent, one-time shock to wealth. In particular, the perceived value of U.S. real estate fell substantially with the 30 percent decline in housing prices after 2006. This shaved trillions of dollars off of the wealth of the nation. Since housing prices are not expected to rebound to the previous peak anytime soon, that wealth is simply gone for now. This has lowered consumption and output, and lower levels of production have caused a significant disruption in U.S. labor markets.

The negative wealth shock lowers consumption and output. But after the recession ends, the economy simply grows from that point at an ordinary rate, neither faster nor slower than in ordinary times. It is more like an earthquake which has left one part of the land higher than another part. There is no expectation of a “bounce back” to a higher level of output after the recession ends.

Huh. I just can't make heads or tails of this idea. It seems to fly in the face of all the most basic intuition macroeconomists possess regarding growth.

Issue #1: A decline in housing prices is not a decline in the stock of productive capital. Houses are mostly consumer durables. A fall in housing prices leaves us with the same number of actual houses as before the crash; yes, that will have supply effects via geographic clustering and relocation costs, but there's no reason to think that these effects are dominating what we see in the economy.

Why does a decline in housing prices leave our economy able to produce less than before? It doesn't seem like it should.

Issue #2: A permanent negative shock to the stock of productive capital, as I mentioned earlier, will lower potential output, but will raise the rate of growth due to the renewed possibility of "catch-up" as we build back up to our old capital/labor ratio. Think of Japan after World War 2. In other words, there should be a "bounce back," directly counter to what Bullard is saying.

So, basically, what we have here is Bullard saying that the neoclassical (Solow) growth model - and all models like it - are wrong. He's saying that a change in asset prices can cause a permanent change in the equilibrium capital/labor ratio.

That is not "crazy talk," necessarily, because it is at least conceivable that the Solow model - and hence, most growth theorists working today - might be completely wrong. But Bullard is going to have a hard time convincing the profession of that. And note that Bullard's contention would also invalidate all business cycle models of the "RBC" type, since those models are based on the neoclassical growth model. Even more deeply, what Bullard is saying is directly counter to our most basic notions of what "capital" is.

For more Bullard critiques, see Scott Sumner and Matt Yglesias, who have already made some of these points.

Bottom line: "We're not as wealthy as we thought we were, and hence we are choosing to buy less stuff" is an argument about aggregate demand, and it is an argument that many people accept. However, "We're not as wealthy as we thought we were, and hence we are able to produce less stuff" makes no sense in the context of any economic theory I know of. Bullard has some serious explaining to do if he wants us to believe the latter.

Thursday Roundup (2/9/2012)

2012-02-09T01:34:00.000-05:00

Seemed like there wasn't much going on in the econoblogosphere this week (I was traveling for most of it, for second-round job interviews). People spent a lot of time discussing Charles Murray's new book, which seems to me a bit like feeding the trolls. The new unemployment numbers came out, and there was some argument over what they mean, but not as much as one might expect. Anyway, here's the links you may have missed:

1. Tyler Cowen discusses the benefits of, and good news about, Latin American immigration to the U.S.

2. Nick Rowe wonders why we don't smooth our consumption of leisure. Interesting question.

3. John Taylor thinks that our economic recovery has been terrible, and continues to be terrible. He chalks this up to the failure of "Keynesian" policies. I think it would be interesting to see him argue with Tyler Cowen, who says that we are having a good, strong recovery, and that this is evidence of the failure of "Keynesian" macro.

4. Scott Sumner reminds us that the Macro Wars are a three-legged race between Keynesians, neoclassicals, and monetarists (instead of a two-sided battle as many seem to think).

5. Brad DeLong, using some simple math, explains his thinking about labor market hysteresis.

6. Rob Johnson of INET interviews Sylvia Nasar about the history of economic thought.

Why rational expectations models can be wrong

2012-02-08T16:57:00.001-05:00

Washington University professor David Levine has a pair of articles (article 1, article 2) in the Huffington Post about why financial crises can't be predicted, and why rational expectations theories are the only good theories in economics. Although I disagree strongly on both counts, Levine's arguments are very thought-provoking.

(As an aside, just to get this out of the way, Levine uses the Heisenberg Uncertainty Principle as an analogy to explain why observer effects make non-rational economic theories fail. This is not a great analogy, since the Heisenberg principle can only be related to observer effects in certain specific situations; also, the Heisenberg principle deals with conjugate pairs of observables, which are different from the kind of observer effects Levine is talking about. This isn't super-relevant, just remember not to get your physics intuition from interdisciplinary analogies. But anyway, back to Levine's ideas...)

Levine's first argument is that financial crises, by their very nature, can't be predicted:

Take an example: how we might predict stock market crashes? Suppose that two behavioral psychologists, call them "Kahneman and Tversky," produce a model of "cognitive biases" that predicts when crashes will occur. The model tells us that the stock market will crash on October 28. Since the model is reliable and has a perfect track record, we naturally believe this prediction. So what would you do? You would sell all your stock on October 27. But of course if enough people do this the stock market will crash on October 27 and not October 28. So this apparently reliable model will be proven wrong.

This is similar to an argument made by Levine's colleague Stephen Williamson. I've addressed this type of argument in the past, but here is a brief recap:

Conditional predictions are different than unconditional predictions. If your modeling goal is to say with confidence that "A financial crisis will occur at 9:01 A.M. on February 17, 2012," then Levine is right; you are probably not going to succeed. However, if your modeling goal is to say: "Unless X policy is taken first, a financial crisis will occur at 9:01 A.M. on February 17, 2012," then you have a chance of succeeding. Why? Because unless investors can predict whether policy X will be taken, then knowing that the model is correct doesn't allow them to make riskless profits. And of course, conditional predictions are the kind policymakers usually care about. So Levine is wrong in cases where policy is decisive.

As a side note, even in cases where Levine is right, this does not make modeling crises a useless exercise. It may be that increasing our understanding of the causes of crises leads to a decrease in the amount of crises rather than an increase in our ability to predict the timing of the crises that do occur. But that's fine! It means that the benefit of better crisis modeling accrued to society instead of to the modelers. That just means that research into the causes of crises generates a positive externality, and should therefore be subsidized by the government and/or some other collective public-goods provision mechanism.

And it means that critics of the econ profession who say "You economists didn't pay enough attention to models of financial crises" can still be right, even if Levine is right!

Levine's next argument is that rational expectations models of the economy are the only models that can be right over the long term:

In simple language what rational expectations means is "if people believe this forecast it will be true." By contrast if a theory is not one of rational expectations it means "if people believe this forecast it will not be true." Obviously such a theory has limited usefulness. Or put differently: if there is a correct theory, eventually most people will believe it, so it must necessarily be rational expectations. Any other theory has the property that people must forever disbelieve the theory regardless of overwhelming evidence -- for as soon as the theory is believed it is wrong.

But notice the logic behind this idea. It assumes that economic theories penetrate the public consciousness and are used by economic actors. Levine postulates that over time, as non-rational-expectations theories are shown to be wrong, economic decision-makers (i.e. you, me, and other folks) will gravitate toward rational expectations theories. This will mean that in the long run, only rational expectations theories will describe the economy. But it also must mean that in the long run, only rational expectations theories will be believed by the public. So if Levine is right, we should see more and more regular people gravitating toward the belief that other people are rational.

Do we, in fact, see this? I am not sure we do. On one hand, index funds are becoming more popular, signifying greater public acceptance of the Efficient Markets Hypothesis. On the other hand, the recent recession probably decreased faith in rational-expectations models of the macroeconomy, both among economists and among the public at large.

So if we don't see people accepting rational expectations theories, then the theory/behavior convergence that Levine talks about is not happening. Meaning that rational expectations theories may well be wrong.

Note that one easy way for rational expectations theories to be wrong is for the average person to simply be dumber than the people making the theories. For example, it's easy to reliably predict the mistakes of rats running in mazes, simply because rats aren't smart enough to learn our theories. Now, obviously, humans are not that far apart in intelligence, but if the difference between different humans is big, it could mean that behavioral theories could consistently be right.

(Does this make behavioral economics elitist? Maybe. But not necessarily. It could be that theorists are smart when making their theories but are dumb at other times. I can personally attest to the fact that this really does happen!)

In his second article, Levine asks how long it takes rational expectations to prevail, and cites the actions of the passengers on Flight 93 on 9/11 as an example of a quick rational response to new information (in this case, the info that hijackers would use planes as weapons). But does this mean that crowds are always rational? There is ample evidence for inefficient herd behavior in the psychological literature.

Anyway, Levine's logic in arguing for the supremacy of rational expectations is subtle and powerful. But I think reality is even more subtle, and even more powerful.

Cochrane on consumer financial protection

2012-02-06T22:32:00.001-05:00

The John Cochrane shadow-blogging continues...

Cochrane has two posts up about consumer financial protection. The first is about the negative impacts of anti-usury laws:

Even a well-intentioned usury law has the unintended consequence that poorer, smaller, less well connected people find it harder to get credit. And it benefits richer, well-connected incumbents, by keeping down the rates they pay, and by stifling upstarts' competition for their businesses...

Here are just a few of the fun facts.
Tighter usury laws led to less credit. People didn't easily get around them.
Tighter usury laws led to slower growth. A one percentage point lower rate ceiling translates in to 4-6% less economic growth over the next decade.
Usury laws only affect the growth of small firms. Big firms do fine...
Now let's think about our massive financial regulation and consumer financial "protection." Let's guess who will end up benefiting...

This seems right to me (and Cochrane cites some research to back up these points). Anti-usury laws don't seem to have worked out too well in the past, either in terms of boosting economic performance or creating a more equitable society. Another downside of such laws, which Cochrane doesn't mention, is that anti-usury laws can lead to the proliferation of mafia loansharks.

The rationale for consumer financial protection in the U.S. - the main argument in favor of the Consumer Financial Protection Bureau - has always been that many modern financial products are too complex for consumers to understand (leading to either people being tricked, or markets breaking down because people fear being tricked). But high interest rates are not complex. They are very simple. People do not need government help to understand high interest rates. This means that the CPFB should ideally focus on complexity (and on behavioral effects that allow companies to repeatedly deceive consumers), not on the tightness of lending standards in general.

Cochrane's second post argues that since regulators are subject to behavioral biases, the CFPB will be no better at evaluating financial products than are the consumers that the agency is meant to protect:

Behavioral economics does not imply aristocratic paternalism. Behavioral economics, if you take it seriously, leads to a much more libertarian outlook.

Which kinds of institutions are likely to lead to behavioral biases: highly competitve, free institutions that must adapt or fail? Or a government bureacracy, pestered by rent-seeking lobbyists, free to indulge in the Grand Theory of the Day, able to move the lives of millions on a whim and by definition immune from competition?

Sure, the market will get it wrong. But behavioral economics, if you take it seriously, predicts that the regulator (the regulatory committee) will get it far worse. For regulators, even those that went to the right schools, are just as human and "behavioral" as the rest of us, and they are placed in institutions that lack many protections against bad decisions.

More generally, the case for free markets never was that markets always get it right. The case has always been based on the centuries of experience that governments get it far more wrong.

This does not seem right to me. I don't think that behavioral theories apply to regulators in the same way that they apply to the people that the regulators are supposed to protect.

For example, many behavioral theories rest on the idea that consumers are overconfident and exhibit considerable self-attribution bias. Regulators, when evaluating a financial product being sold by Company A to Consumer B, will presumably suffer from these same biases, but not in the same way. An overconfident consumer may say "Housing prices will always go up," even if a dispassionate analysis says that they won't. A regulator, by contrast, may be overconfident in general, but she won't be overconfident about the price of the consumer's house!

So, just saying "regulators are people too" doesn't prove anything. The point of behavioral economics is not just to say that "people make mistakes"; it's to point out what kind of mistakes people make, and when.

(I should note that variants of this argument - "Governments make mistakes too!" - are extremely common among opponents of regulation. But just to say "Governments make mistakes, therefore we shouldn't rely on government for things" seems very wrong to me. We need to study what kind of mistakes governments make, and when. Otherwise we risk making the perfect the enemy of the good.)

Lower wages can be a good thing

2012-02-04T15:51:00.001-05:00

Menzie Chinn points out that recovery in manufacturing and exports has been stronger than recovery as a whole. As an explanation, he cites America's falling unit labor costs. Unit labor cost is just the amount of wages you need to pay workers to produce one unit of output. Because America's unit labor costs are falling, it is becoming more economical for businesses to produce more tradable goods here, and so they are doing so.

This is a useful reminder of a economic principle often overlooked by progressives: There is sometimes a tradeoff between wages and employment levels (which is another way of saying that labor supply curves slope up and labor demand curves slope down). If economic "frictions" or the actions of policymakers hold wages up when economic forces are trying to push wages down, unemployment will often result.

In the case of trade, what this means is that keeping American wages high can cause unemployment to rise. Starting around 2000, a huge massive glut of Chinese labor was dumped on the world market when China joined the global trade system; this created a tremendous natural downward pressure on American wages. Wages in America have stagnated since 2000, but it's difficult for wages to actually fall. This wage rigidity probably shrunk the size of America's tradable sector.

But eventually, increases in American productivity have caught up and overtaken stagnant American wages. Here is Chinn's graph:

If you believe Chinn's story, the slow growth of U.S. wages is behind the mini-resurgence in American manufacturing and exports. This is the reality of "competitiveness."

Is this a good thing or a bad thing? Well, if what you care about is higher wages for the people who have jobs, then no. But if what you care about is increasing the total number of people with jobs, then yes. If you believe that our social safety net is good enough to provide for the unemployed by taxing the employed (ha), and that the efficiency losses from artificially high wages are small, then maybe you don't care.

Another example of a tradeoff between wages and employment is in sticky-wage models of the business cycle. In these models - which include many New Keynesian models - wage frictions can increase unemployment by preventing nominal wages from falling in response to a negative demand shock. (Of course, in these models, the optimal solution is for government to use policy to cancel out the demand shock, thus preventing wages from falling while preserving employment levels.)

Lots of people don't like the idea that there is a tradeoff between wages and employment levels. They point to the long run, in which (hopefully) wages rise without causing long-term unemployment. But the short-term is different than the long term. In the case of sticky-wage models, the "short term" may only be a few years. But in the case of trade, China, and "factor price equalization," the "short term" may last until China's wages catch up to ours. That could take decades.

I believe that the mindset of some progressives - maximize wages at all costs - needs a rethink. When I look at the evidence, I see that higher wages do only a little to increase the happiness of workers, but unemployment is devastating for the unlucky few (and terrifying even for those who manage to keep their jobs). In Germany, labor unions often negotiate wage cuts in order to preserve long-term employment levels. I think we should look at doing something similar. After all, Germany is no blue-collar dystopia.

It seems weird, but lower wages can be a good thing.

Tyler Cowen pounces on Keynesianism

2012-02-03T12:51:00.013-05:00

The new payroll numbers are out, and the numbers are good. Tyler Cowen interprets the numbers to be a big refutation of Old Keynesian macroeconomic theories:

The “big loser” here?: Old Keynesianism. You really can get a recovery when the real shocks are moderately positive. You will note, as we have been told many many times by many many sources, fiscal and monetary policy have not been extremely pro-active in recent times; in fact the stimulus has been trickling to a close. The big winners, apart from the American public?: real business cycle theory. It is part of any cyclical explanation, whether one likes it or not.

Another big loser is those liquidity trap theories which tell us that positive real shocks are bad for the economy because the AD curve has a perverse slope, etc., and that negative shocks might help spur recovery. That theory is looking very weak, again. I consider it the weakest economic theory that has any currency in the serious economics blogosphere.

In response, Ryan Avent tweeted: "What on earth is Tyler Cowen talking about?" I have to say, I share Ryan's sentiment. Here are the issues I have with Cowen's interpretation of the data:

1. This is one month of data. I think it may be time to add another principle to my list of Principles for Arguing With Economists: "One-Tick Economics" does not work. Time series are stochastic; one month of data, no matter how good or bad, is not enough to refute or support any macoreconomic theory. For reference, courtesy of Brad DeLong, here is a graph of the labor force/population ratio, with the most recent good news highlighted at the end:

Look carefully at that graph. Do you think that tick is enough to disprove Old Keynesianism and the liquidity trap, and provide strong support for Real Business Cycle theory? Tyler says yes. I say: Highly unlikely. To evaluate their models, macroeconomists look at time series containing hundreds upon hundreds of such data points, and it's still incredibly difficult to evaluate competing macroeconomic theories. One more month is not going to come along and settle the argument. Sorry. It just isn't.

And did Cowen seize on every month of terrible employment growth over the past three years to say "Wow, Real Business Cycle is the big loser from this data, and the big winner is Old Keynesianism!"? No, he did not.

2. Growth rates and levels are different things. Even if last month's good numbers signal that the economy is recovering, it is still in a deep hole. It has not recovered yet. To support this contention, let me cite a post from Tyler Cowen from two days ago:

[W]hat is striking about the broken line above isn’t where it now ends — at 10.3 per cent — but rather the lack of any meaningful, sustained improvement for more than two years.

This alternative measure [of unemployment] has remained above 10 per cent since September 2009, and aside from a bit of skittishness (some of which is down to uncaptured seasonality) has mostly just moved sideways.

So, over two years of complete employment stagnation do nothing to strengthen the case for liquidity traps in Cowen's mind, but one month of good employment numbers relegate Old Keynesianism to the dustbin of history. Right. Got it.

3. The "liquidity trap" is not as bad as it was before. Tyler apparently believes that liquidity trap theories dictate that an economy in a liquidity trap must experience poor employment growth each and every month of the year, unless and until the government launches a sufficiently large intervention. That is a massive, ridiculous straw-man. Liquidity traps are not held to last forever. In fact, here is evidence from Greg Mankiw that the U.S. may be out (or almost out) of a liquidity trap.

4. Where's the "real shock"? Tyler Cowen says that the latest data show that "You really can get a recovery when the real shocks are moderately positive." Does he have any data to show that we have experienced a "moderately positive real shock"? What kind of shock is he talking about? A positive technology shock? An uptick in people's willingness to work? I want to see this shock identified! (And make sure it's a structural shock..."higher manufacturing orders" does not count.)

More broadly, Cowen says: "The big winners, apart from the American public?: real business cycle theory." So, presumably, the three straight years of poor economic performance were caused by negative real shocks? By poor technological progress and/or people deciding they'd rather not work? Is Cowen really willing to make that argument?

To conclude: I am not saying that Old Keynesianism is right. I am not saying that liquidity-trap theory is right. What I am saying is that one month of data does not prove these theories wrong at all, especially when employment is still far below previous levels, and especially when there is evidence that the "liquidity trap" is not as severe as it once was. And what I am saying is that this one month of data does not in any way represent a vindication for Real business Cycle Theory, especially if I can't see the "real shock."

Look, if you sit through three years of economic stagnation, watching and waiting for any single month of good employment data, and then as soon as one comes along you jump out and pounce and yell "See? Keynesianism is wrong, Real Business Cycle Theory wins!!!", well, eventually you're going to get your chance. But your conclusion, from a scientific standpoint, will be incredibly premature.

Show me half a year of solid growth under a regime of relative austerity and hard money, and I promise you I will seriously re-evaluate any and all of my own ideas about the relative importance of "real" and "nominal" shocks. We aren't there yet.

Update: Brad DeLong, quoting Keynes, reminds us that Old Keynesians believe that economies eventually recover without stimulus; they just think that stimulus makes them recover faster. Does Cowen really think that Old Keynesians believe that an economy will never emerge from recession without government action???

Update 2: Tyler Cowen has a lengthy response. His points:

* He says he against Old Keynesianism but not New Keynesianism (fair enough).

* He says that Old Keynesiansm predicts less mean-reversion in growth than does New Keynesianism (not sure that is right, see DeLong post above).

* The "recovery" is coming right after the end of fiscal stimulus (not a strong argument; including state govt. spending there was no stimulus)

* The Old Keynesian "paradox of thrift" seems to be more applicable in the middle of a crisis than during a slow recovery (um...that sounds to me like a vote of confidence for Old Keynesianism...)

* The Mortensen-Pissarides labor search model matches RBC theory, not Keynesianism (um...that's because RBC is part of the Mortensen-Pissarides model. Which, as it happens, also doesn't match a lot of important fact about recessions, as Robert Shimer has pointed out.)

* Corporate profits are strong (This actually is much worse news for New Keyensianism than Old!)

* "Real business cycle" models actually include most economic models and phenomena (Except, of course, all models that are used by central banks and professional macro forecasters!)

So, there you go.

Thursday Roundup (2/2/2012)

2012-02-02T02:36:00.003-05:00

Posts you may have missed in the blogosphere this week...Ride em econ cowboys!

1. Matt Yglesias reminds us that it is never wise to give our money to the experts, no matter how much money they make for themselves.

2. Tyler Cowen argues that inequality, at least recently, has been mostly about stagnating incomes and the explosion of the income of the top 0.1%. Very true. (Tyler's post also contains some insults in an addendum at the bottom, which I do not endorse.)

3. John Cochrane demonstrates the perils of over-differencing time series data. This is a specific case of a very deep problem with time series econometrics: rigid lag structures.

4. Steve Keen has a great essay on the problems facing the field of macroeconomics.

5. James Kwak explains how private equity works, how it is is supposed to benefit the economy, and how it might not actually benefit the economy.

6. David Glasner reminds us that Reagan didn't think 4% inflation was such a bad thing.

7. Brad DeLong uses an equation to explain his thinking on fiscal policy. Unlike a lot of people in the blogosphere, I love it when people do this. And here, he explains his thinking on monetary policy. Read!

8. Scott Sumner points out that Britain talks a lot about austerity but has actually been running big budget deficits.

9. Intra-blog civil war at Modeled Behavior, as Karl Smith doubts that government workers can be overpaid, while Adam Ozimek thinks they most definitely can. I score this one for Adam (to see why, consider the marginal product of Chairman Mao and compare it to his total compensation package). In fact, Adam is so obviously right that I hereby award Karl a bat boy! ;-)

Who cares how "deserving" the poor are?

2012-01-29T04:13:00.007-05:00

Bryan Caplan is apparently about to debate Karl Smith on the question of "How deserving are the poor?" I want to get my two cents in ahead of this debate, by asking the counter-question: "Who cares?"

The question of "How deserving are the poor" is a matter of opinion. There is no right answer, because to say someone "deserves" something is a prescriptive statement, and you can't prove those with facts. Also, it is a somewhat pointless question, because no matter what answer you decide you like, it doesn't really imply any particular policy prescription. In practice, people who say "The poor deserve to be poor" are usually just trying to push the idea that we shouldn't try to do anything about poverty other than scolding the poor for their own mistakes (I'll come back to this idea in a bit). But this doesn't really follow.

As I see it, there are two important questions about poverty from a policy perspective:

1. Do we want to make poor people less poor?

2. If we do want to do that, how do we accomplish it?

Bryan Caplan's answer ~~(and Tyler Cowen's)~~ to the question of "How deserving are the poor" is that if people are poor mainly as a result of their own actions, then they deserve to be poor. But as I see it, whether people are poor because of their own actions doesn't really help us answer either of the two questions I posed above.

Regarding the first of my questions, "Do we want to make poor people less poor", it may be that your sense of morality tells you that if someone is in a condition as a direct result of their own actions, it would be wrong to try to remove that person from that condition. Fine, good for you and your sense of morality! But for my part, I simply don't care. If I am getting mugged by a poor person, I quite frankly do not give a rodent's gluteal region whether that person is poor because he made bad life choices or because the circumstances of his birth made his poverty inevitable; I want him to stop mugging me, and if making him less poor will make him stop mugging me, then maybe this would be a good thing to do, regardless of whether he "deserves" it. When I witness the urban blight, violence, drug abuse, and other social ills that poverty may be causing, as a non-poor person I have an interest in preventing these social ills from affecting me, regardless of whether the ills are "deserved."

Also, whether people are poor because of their own actions doesn't really tell us how to get them out of poverty. Scolding and finger-wagging does not work. Just because a person's actions got him into a situation doesn't mean that his actions can get him out of it. And even if poor people could raise themselves up out of poverty at any time, scolding and finger-wagging is not likely to induce them to suddenly do so. The conservative solution to poverty - make it really, really unpleasant to be poor, and then hope people will do the smart thing and avoid it - has failed and failed and failed again.

So from my point of view, asking whether or not poor people "deserve" their poverty is asking the wrong question.

That said, I think the Caplan definition of "deserve" is not as "uncontroversial" a moral premise as Caplan declares. The reason is that it is a partial-equilibrium definition, not a general-equilibrium one. If we live in a society in which X percent of the populace must be poor, then no matter what set of actions is taken by the population, some people will wind up in poverty. To see this, imagine that we lived in a society in which the hardest-working 50% of people get to be spectacularly rich, and the other 50% are forced to live in squalid poverty. In this society, if everyone raises their effort by 1000%, the number of people in poverty stays exactly the same. I doubt that most people would say that the lower half of the population "deserved" to stay in poverty after raising their effort by 1000%! But that is exactly what Caplan's definition implies. Also, note that in such a world, whether you "deserve" to be poor depends critically on the actions of other people (since the degree of effort required for a person to raise himself out of poverty depends on how much effort others are expending)...thus, Caplan's definition doesn't really seem to capture the notion of individual responsibility.

But anyway, that is a bit beside the point, because in my opinion the whole question is a bit of a pointless one.

Update: Tyler Cowen emails to say that his view of "deserving" is a more synthetic one than Bryan Caplan's. Also, in his post he says "There is the view that desert simply is not very relevant for a lot of our choices. We still may wish to aid the undeserving." This is pretty close to my thoughts.

Alex Tabarrok: Public goods, public goods, public goods!!!

2012-01-27T13:25:00.001-05:00

It is difficult to overstate the intensity of the warm glow that fills my heart to see Alex Tabarrok writing this in the pages of the Atlantic:

To build an economy for the 21st century we need to increase the rate of innovation and to do that we need to put innovation at the center of our national vision...Innovation, however, is not a priority of our massive federal government. Nearly two-thirds of the U.S. federal budget, $2.2 trillion annually, is spent on the four biggest warfare and welfare programs, Medicaid, Medicare, Defense and Social Security. In contrast, the National Institutes of Health, which funds medical research, spends $31 billion annually, and the National Science Foundation spends just $7 billion...

The federal government does spend some money on innovation, but mostly for innovation in warfare...The basic and applied non-weapons research that has the best chance of creating beneficial spillovers is a small minority of defense R&D. DARPA, the Defense Advanced Research Projects Agency, for example, helped to develop the Internet but DARPA's budget is only $3 billion. Even when we lump all federal R&D spending together regardless of quality it amounts to just $150 billion, a mere 4 percent of the budget...

Our ancestors were bold and industrious. They built a significant portion of our energy and road infrastructure more than half a century ago. It would be almost impossible to build that system today. Could we build the Hoover Dam today? We have the technology. We seem to lack the will. Unfortunately, we cannot rely on the infrastructure of our past to travel to our future. Airports, an electricity smart grid that doesn't throw millions into the dark every few years, and ubiquitous Wi-Fi are among the important infrastructures of the 21st century, and they are caught in the regulatory thicket...

To restore our economy and our spirits we need to become an innovation nation. An innovative nation would improve the prospects for economic growth but could do much more. The warfare-welfare state divides the pie and also divides Americans. Americans, however, are an innovative, forward-thinking people and the prospects are good for uniting them on a pro-growth, pro-innovation agenda.

In other words: PUBLIC GOODS PUBLIC GOODS PUBLIC GOODS!!!

Also known as "public investment," "government investment," "public capital," "government capital," "partially nonrival production inputs," etc, public goods have been a major theme of this blog.

To see Alex Tabarrok trumpeting the importance of public goods is particularly gratifying to me, since Alex writes for Marginal Revolution, a blog whose leanings I would characterize as "libertarian," and works for George Mason University, an institution whose intellectual climate I would characterize as "libertarian." Which means that this article is part of the growing libertarian push for public goods, which first came to my attention from Peter Thiel.

In the 1970s and 1980s, libertarians and conservatives were so focused on shrinking the regulatory and welfare states that they were willing to throw the baby out with the bathwater. The crucial role of research and infrastructure in an advanced economy was ignored by cries to "drown the government in a bathtub," or that "government is the problem." The price of this epochal oversimplification is today's crumbling infrastructure and shrinking research budgets.

Republican politicians, meanwhile, focused almost exclusively on distributional issues instead of on growing national wealth - "dividing the pie and dividing Americans," to use Tabarrok's pithy phrase. The national-greatness conservatism of a century ago was forgotten, replaced with a complacent belief that America's greatness was on autopilot.

I have no idea how politically conservative Alex Tabarrok is, but I do know that the conservative movement desperately needs him as a thought leader. America needs more and better public goods, and we need conservatives on board if we are going to get those goods. But conservatives are never going to listen to liberals. If Paul Krugman gets up and says "We need a strong social safety net AND more spending on research and infrastructure," conservatives are going to see public goods as a Trojan Horse for socialism. But if libertarian George Mason profs and Silicon Valley venture capitalists get up and say "We need to shift resources from the social safety net to research and infrastructure," then conservatives just may perk up and listen.

What we need in this country is an Alex Tabarrok conservatism.

(Note: I do actually have one quibble with Tabarrok's excellent article. He lumps Social Security in with the "welfare state," but most Social Security spending is really just forced saving. To maintain payroll taxes at current levels but shift Social Security spending from pension benefits to public goods would be to invest the savings of a large chunk of Americans in a set of risky projects whose payoffs would be distributed very unevenly. Not a lot of Americans are going to go for that. So I recommend leaving Social Security out of the discussion, and focusing instead on shifting resources away from health care spending.)

Standard Republican narrative of history (John Taylor edition)

2012-01-27T02:55:00.005-05:00

According to John Taylor, the reason that the recovery from the 2008-9 recession has not been as rapid as the recovery from the 1981-2 recession is that Reagan's policies were better than Obama's policies:

We are not really recovering from the recession, at least not compared to the period after previous big recessions such as the early 1980s...The reason is pretty clear. In the Wall Street Journal piece I refer to and quote from a memo written by President Reagan’s economic adviser George Shultz and others after the 1980 election. It laid out the long run economic strategy they recommended and which Reagan followed. Contrast that with the memo Larry Summers sent to President-elect Obama after the 2008 election, which is making the internet rounds. It laid out the short-run Keynesian policy Summers recommended and which Obama has followed. The big policy differences largely explain the big economic performance differences. (emphasis mine)

And what are those big policy differences? In the WSJ article, Taylor spends a lot of time making a general case for "economic freedom," but names only one concrete policy difference between Reagan and Obama: Reagan enacted permanent tax cuts, while Obama enacted temporary tax rebates (in the ARRA). Taylor argues that Reagan's permanent tax cuts represent policy based on predictability and stability, while Obama's policies represent short-term, unreliable interventions.

This is a very standard intellectual-Republican narrative of economic history. Which, again, does not mean it is wrong. But I do see some big problems with Taylor's analysis.

Problem 1: Reagan's permanent tax cuts were enacted in early 1981, before the steep recession. This means that any effect that those tax rates had on the 1983 recovery had to have come not from the policy change, but from the low tax rates that were in place. However, in 2010, thanks to the Bush tax cuts, stable permanent long-term income tax rates were lower under Obama than they were under Reagan. If low permanent tax rates caused a rapid recovery in 1983, why didn't even lower permanent tax rates cause a rapid recovery in 2010?

In other words, if the 1981-2 recession was fundamentally the same kind of event as the 2008-9 recession, then Taylor is concluding that Obama's temporary tax cuts (or other actions, such as saying bad things about "business") substantially prolonged the current slump. I suppose that is possible - it's a claim that many Republicans have repeated - but it seems like a difficult case to make. A lot harder of a case, in fact, than simply saying "Reagan's policies were better than Obama's."

Problem 2: There are other historical examples of deep recessions besides the one in the early 80s. When we compare policies and results between now and the Great Depression, for example, especially in Britain, we are tempted to reach conclusions very different from Taylor's. I'll outsource this part of the argument to Brad DeLong:

This many months after the start of the Great Depression, the British economy was rapidly converging back to its pre-depression level of production under Chancellor of the Exchequer Neville Chamberlain's policy of using stimulative policies to restore the price level to its pre-Great Depression trajectory.

By contrast, the Cameron-Osborne policies of expansion-through-austerity have produced a flatline for real GDP, and the odds are high that British real GDP is headed down again.

In less than a year, if current forecasts come true, the Cameron-Osborne Depression will not be the worst depression in Britain since the Great Depression, but the worst depression in Britain… probably ever.

So if you want to ascribe economic outcomes to broad differences in economic policy, why only look at the Reagan years? Why not look at the Depression? And why look only at the U.S. instead of at other countries as well?

Problem 3: The 2008-9 recession does not seem very comparable to the 1981-2 recession. For one thing, the early 80s recession immediately followed (and, most believe, was precipitated by) a huge hike in interest rates by the Federal Reserve (which was trying to beat inflation). That meant that as soon as rates were allowed to fall, the force that had spiked U.S. GDP growth would be removed. In contrast, the 2008-9 recession occurred during a period of historically low interest rates, which were dropped to zero shortly after the recession began. This left the Fed without its usual method of boosting GDP growth. Even more importantly, the difference also indicates that the "shocks" that caused the two recessions were fundamentally different - a policy shock in the case of the early 80s recession, but some other kind of shock in the case of the 2008-9 recession.

In other words, I think this simple standard Republican narrative does not fit the facts. It is tempting, especially for politically conservative economists, to conclude that Reagan's tax cuts made everything about the U.S. economy awesome, and that something done or said by the left-leaning Obama made everything go wrong. But that conclusion just doesn't square with the evidence that we see when we look out the window. I think a more complex narrative is needed.

Update: Paul Krugman points out that Reagan raised taxes in 1982. Which means that A) Reagan's 1981 tax cuts were not quite as predictable, stable, and long-term as Taylor claims, and B) according to Taylor, this Reagan policy should have hindered the 1983 recovery.

Thursday Roundup (1/26/2012)

2012-01-26T00:57:00.004-05:00

New feature, y'all! I've decided to join the ranks of the aggregators, and post a weekly roundup of interesting posts from around the econ blogosphere that I didn't see get discussed very much. Here's this week's list:

1. Paul Krugman reminds us that debt bubbles are much, much worse than equity bubbles. This is relevant for my own research, since debt bubbles are often housing bubbles, and housing investors are often unsophisticated, liquidity-constrained, and prone to various behavioral biases.

2. Matt Yglesias basically reprises my "Great Relocation" idea - economic activity is moving to Asia because Asia has the densest populations. Of course, we both got the idea from Paul Krugman. Update: Ryan Avent, too.

3. Mike Konczal interviews Josh Kosman, who explains how the private equity tax arbitrage scam works.

4. Brad DeLong offers some helpful tips on the difference between behavioral relationships, equilibrium conditions, and accounting identities in economic modeling. Yay Principle #4!

5. Frances Woolley gives an excellent explanation of what econ blogs contribute to the academic discussion. Basically, assumptions are crucial to econ models, and blogs can examine the plausibility of assumptions.

6. Tyler Cowen explains the asymmetric nature of financial bets on volatility, and how a little moral hazard can go a long way.

7. My sources indicate that this email in Tyler Cowen's inbox, complaining about rude bloggers, is about me. Really? Am I really that rude? I guess it's easy to sound harsher on a blog than one intends to be (an effect that is noted in the immediately prior Tyler Cowen post).

8. Tim Duy uses Japan's experience in the 1990s to illustrate how fiscal policy can turn into fiscal capture...

9. Ryan Avent discusses how land use policies hold down real wages in Silicon Valley and transfer wealth from engineers to landholders.

Cochrane: Just don't call it "stimulus"!

2012-01-24T12:20:00.008-05:00

John Cochrane has a long blog post up, the first half of which is a general discussion of the idea of fiscal stimulus, and the second half of which is a rant about how mean Paul Krugman and Brad DeLong are. I'm going to talk about the first half.

Cochrane writes:

Let's be clear what the "fiscal stimulus" argument is and is not about.

It is not about the proposition that governments should run deficits in recessions. They should, for simple tax-smoothing, consumption-smoothing, and social-insurance reasons, just as governments should finance wars with debt. That doesn't justify all deficits -- one can still argue that our government used the recession to radically increase permanent spending. But disliking "stimulus" is not the same thing as calling for an annually balanced budget.

Nor is it about debt financing of "infrastructure" or other genuine investments. If the project is valuable, do it. And recessions, with low interest rates and available workers, are good times to do it. That doesn't justify all "infrastructure" roads and rails to nowhere, of course...

The "stimulus" proposition is that additional spending -- whether needed or not -- raises output and general welfare. Pay people $1 to dig ditches and fill them up again, and the whole economy gains $1.5. (emphasis mine)

So Cochrane:

1. Is against austerity during recessions, and

2. Is in favor of increased public investment during recessions.

But countercyclical deficits and countercyclical public investment do not, in his terminology, represent "stimulus"; that term is reserved for the Old Keynesian hole-filling sort of spending. And what does Cochrane think about that sort of stimulus?

Stimulus [is] still an economically interesting proposition, and there is a great deal of uncertainty about whether, when, and how well it might work. There is a huge academic literature being produced right now...

Here are the facts. Some economic models do predict a fiscal stimulus effect. Some don't...The facts are far from decisive...So, there is a lot of uncertainty and a lot we don't know about how the macroeconomy works. (emphasis mine)

And my response to this is:

!!! o_O !!! <-- (this is an "emoticon" that indicates surprise)

If I told you that a famous economist thought that austerity is a bad idea in recessions, that recessions are a great time to boost debt-financed infrastructure investment, and that additional Keynesian stimulus spending was an "economically interesting proposition" about which the jury was still out, would you guess that the economist was John Cochrane? Before I read this post, I would not have. But hey, that's cool!

Actually, the parts of Cochrane's post that I quoted above almost perfectly sum up my views on stimulus. Although I'm convinced that recessions are caused by demand shocks, I don't really know enough to firmly believe that burying jars full of money would substantially boost aggregate demand. I don't know enough to accept or reject IS-LM or a New Keynesian model as my working model of the macroeconomy.

But right now, who cares? The fact is, we know we have a huge shortfall of infrastructure spending. Our existing roads and bridges - which clearly do NOT lead to "nowhere" - are falling apart. Even Obama's ARRA "stimulus" did very little to correct the problem. And instead of borrowing more money to fix our crumbling public goods, at a time when borrowing costs are historically low, conservatives are demanding that we tighten our belts and "starve the beast." We are not even close to addressing the question of whether to bury jars full of money.

I think the conservative push for austerity and reduced infrastructure spending is just nuts, and from what Cochrane has written above it seems he would probably agree. If we were to embark right now on a massive debt-financed program of road and bridge repair, that would not meet Cochrane's definition of "stimulus" (thought it would certainly be labeled "stimulus" in the press). It would consist entirely of policies for which Cochrane has expressed unqualified approval.

So why doesn't Cochrane stand up and loudly advocate a massive debt-financed program of road and bridge repair? Is it because the public might get the wrong idea, and start believing in "stimulus" of the hole-filling variety? Is it because infrastructure investment must be politically sacrificed in order to "starve the beast" and fight against creeping socialism? Is it just because Paul Krugman and Brad DeLong are mean mean meanies?

For crying out loud!

I may be wrong, but it seems to me that politics and/or personal feuds have contaminated the public debate over fiscal policy.

Update: Matt Yglesias says I want to "continue the argument" about stimulus. But actually, that's the opposite of what I want! What I want is for people to stop worrying about who is a meanie, and start trying to find as much common ground as they can. If a massive deficit-financed program of road and bridge repair is something that Paul Krugman and John Cochrane can agree on, then I think they should unite and push for that, and if that actually gets done, there will be plenty of time later to argue over whether "stimulus" in the strict sense is a good thing or a bad thing. But right now, it seems like there might be real common ground that is getting obscured by some of the rancor and politics.

The real multiplier vs. the nominal multiplier

2012-01-23T01:55:00.004-05:00

I've been having some interesting email discussions with Scott Sumner, and thus it is time for a macro post.

Scott Sumner and David Beckworth have recently been arguing that, once you take the Fed into account, the Keynesian multiplier (the effect of fiscal spending on GDP) is zero. This is true, they say, because the Fed acts to counteract any unusually rapid rise in nominal GDP. The idea is basically this: after a recession ( a fall in nominal GDP), in order to return to its previous trend, NGDP must grow faster than its trend rate of growth. But since NGDP = real GDP + inflation, and since a stimulus increases aggregate demand, this will involve higher inflation as well as faster growth. The Fed, Sumner and Beckworth hypothesize, will not allow higher inflation, and so will raise interest rates, thus canceling out the effect of the stimulus on aggregate demand. The multiplier, when measured in NGDP terms, and when defined to take the Fed's "reaction function" into account, will be zero.

Now, in the past, I've argued that the Fed would have to be crazy to do this. It would have to refuse to allow NGDP to grow fast in a recovery even after NGDP plummets in a recession. But maybe the Fed is crazy! If the Fed actually does have an emotional bias against inflation - which some people argue is a desirable quality in Fed governors, because it helps anchor low inflation expectations - then it just might do something very much like what Sumner and Beckworth imagine.

However, does this mean that fiscal stimulus is ineffective? I say no. Why? Because that would only be true if fiscal and monetary policy had identical and opposite effects on inflation expectations.

Realize that when we talk about the fiscal "multiplier," we're taking about a real multiplier - the effect of spending on real gdp growth. The growth rate of NGDP is equal to the real growth rate plus the rate of inflation. So it's possible for the real growth rate to rise in response to a stimulus while the nominal growth rate stays the same. This will happen if inflation falls. For example, you could go from having a 2% RGDP growth rate with 3% inflation before the recession, to a 4% RGDP growth rate with 1% inflation after the stimulus. NGDP growth is 5% before the recession and 5% during the recovery, but RGDP growth is different.

This is called a disinflationary boom. In the case of a stimulus-induced disinflationary boom, the real multiplier is nonzero even after taking the Fed's inefficiently hawkish reaction function into account.

How can a disinflationary boom happen? Well, inflation is determined in large part by expectations of future inflation. If the combination of fiscal stimulus and higher interest rates caused inflation expectations to be lowered (perhaps by giving the Fed an opportunity to prove its hawkishness), the Phillips Curve would shift downward, meaning you could get more real growth for any given rate of inflation. That would allow a disinflationary boom. The stimulus would push RGDP back to trend after a recession, while a permanent change would remain in the NGDP time series. In fact, if the episode increased the Fed's credibility in the long term, the combination of policies would have benefits beyond the effect of the stimulus.

Some people might argue that this describes the 1980s. Reagan's tax cuts, this story would say, acted as a Keynesian demand-boosting stimulus that raised RGDP growth, but that the accompanying inflation was tamed by the hawkish Volcker Fed. I'm not sure I believe that, but it at least sounds plausible.

Anyway, the upshot is that a nominal multiplier of zero, caused by a pathologically hawkish Fed, does not necessarily mean that the real multiplier - the multiplier we care about - must be zero.

Scott Winship fails to show that Alan Krueger is a liar

2012-01-19T13:22:00.007-05:00

Ever since Council of Economic Advisors chair Alan Krueger gave a speech on inequality, conservative media have been hard at work trying to debunk his claims. Increasingly, the go-to numbers guy on the right is Scott Winship of the Brookings Institute, who has written a series of articles at the National Review. Several of these articles have recently been linked and praised by Tyler Cowen.

Cowen's most effusive accolades were reserved for this piece, about which Cowen says "The post is excellent throughout and it contains many more points of interest." So I thought I'd take a look at this "excellent" Winship post and see what it had to offer. What I found, disappointingly, was a mix of insults, value judgments masquerading as refutations, dubious logic and concern trolling. So I thought I'd do my usual thing...go through the piece point by point, so readers can see why I reached the conclusions I reached...

Warning: This gets long.

Winship writes:

[T]he more Obama can make the election about big-picture economic issues like inequality and mobility, the less flack he will take for the more immediate problem of a still sluggish economy...

I’ll be honest—I have a fair amount of sympathy for much of President Obama’s agenda...I am even open to the idea that our high levels of inequality are problematic...But I am exasperated by the Administration’s casual claim that opportunity in the U.S. for the typical American is on the decline...

The president’s strategy may prove successful, but it could have the shameful effect of unnecessarily raising Americans’ economic anxiety levels...Even worse, by talking down opportunity, the president could actually depress upward mobility.

As you can see, the concern-trolling has already begun. "I support Obama and care about inequality...I'm just pissed about his lack of empirical rigor! Oh, and also he's just trying to scare Americans and distract them from our real problems for his selfish political gain. But no really, I'm just a dispassionately concerned data guy!"

But then the real kicker comes in this line:

The latest attempts to justify this claim [of reduced opportunity], in Krueger’s speech, have crossed the line from ill-supported to deceitful.

Oh, so Krueger is a liar, is he???

I say that if you are going to call a respected economist a liar, you had better have some pretty damn good evidence to back that up. Let's see if Winship has the goods on Krueger.

The first thing Winship does is to recap his past successes against the Obama administration. He links back to an earlier piece of his that cast doubt on an earlier administration claim that economic mobility in America has decreased in recent years. On balance, that earlier piece is much more convincing (and less calumnious) than the current piece, so I will give Winship a pass on this point; let's assume that it's not clear that mobility has really fallen in America. However, as Winship notes, the numbers he criticized in the earlier piece were not included in Krueger's speech...so let's turn to what Krueger actually said in his supposedly "deceitful" speech.

Winship next attacks Krueger's contention that the American middle class is shrinking:

Krueger presented estimates indicating that the percentage of American households who were in the middle class fell from 50 percent in 1970 to 42 percent in 2010...I was surprised to realize that the Administration had defined “upward mobility into the middle class” in such a way that it did not count “upward mobility into higher-than-the-middle-class.” This…unusual definition had the effect of understating how many poor people become at least middle class, which is certainly the relevant figure.

Krueger’s claim of a shrinking middle class relies on the same peculiar definition. Specifically, “middle class” is defined as having a household income at least half of median income but no more than 1.5 times the median. I re-ran the numbers using the same definition and data source as Krueger and found that the entire reason the middle class has “shrunk” is that more households today have incomes that put them above middle class...

A shrinking middle class is only a problem if it reflects fewer people reaching the middle class. That is clearly the impression the administration wants to give, but it is entirely dishonest to do so.

Winship presents this as a refutation, but it is actually a value judgment. Krueger is talking about inequality, and he presents numbers on inequality. Winship is saying "No, you shouldn't care about inequality, you should only care about absolute income levels and the upward mobility of the poor."

Put another way, imagine if everyone makes $10,000. Then imagine a couple of people's income goes up to $1,000,000 while everyone else stays the same, thus shrinking the middle class. Would you, the voting citizen, have a problem with this if it happened? You might, and you might not. But if Krueger and Obama think that inequality is a problem in and of itself, who is Winship to tell them to think otherwise? Just because Krueger chose not to focus on what Winship believes is "the relevant figure" and the "only important" issue does not mean that Krueger is "dishonest." A value judgment is not a refutation! (Time for a Principle #8?)

But there's another problem with Winship's claim. Yes, it is true that from 1970 to 2011, the shrinking of the middle class, on net, reflected (unequal) upward mobility out of the middle class. That is because absolute incomes themselves increased a lot between 1970 and 2011. But if you look at the period from 2001-2011, it is a different story entirely. In that period, median household income fell substantially. The "middle class," which is defined relative to median income, thus became poorer over that time. In other words, since 2001, poor people could move into the "middle class" without making a dime more in income; the middle class came to them. And this is what Winship calls "upward mobility"!

Winship paints a picture of an America that is becoming more unequal only because a rising tide is lifting some boats faster than others. That may have been an accurate picture in the 80s, but it has not been accurate for over a decade.

Next, Winship takes on the much-talked about "Great Gatsby curve," which shows a cross-country correlation between income inequality and intergenerational mobility. The first thing he does is to cast doubt on the cross-country data, citing several ways in which these might be mismeasured. These complaints are certainly valid, but do they refute Krueger's point...or reinforce it? I hereby outsource my argument to Justin Wolfers of the Freakonomics blog:

Basically, Winship has a bunch of complaints about how the data are constructed — and many are valid...It’s a standard play from the wonk-fight playbook: throw lots of mud at the data, and hope that this leads people to mistrust the conclusions that follow.

Here’s the thing: his criticisms actually strengthen the original finding.

Think about it. Imagine how strong the “true” relationship must be if it shows up even when using only rough proxies for the “true” levels of inequality and immobility. In light of Winship’s criticisms, the high correlation in this chart is all the more remarkable. If his gripes are correct, then graph understates the correlation between inequality and mobility...

[If] the data are a pretty poor proxy for what’s really happening...there’s actually a very strong link that’s being disguised by imperfect data.

So if the relationship between inequality and immobility holds across multiple data specifications, then Winship's "critique" is just proving Krueger's point. But maybe the Obama administration just cherry-picked the one data specification that seemed to show a relationship? Ah, but no. In his next paragraph, Winship writes:

Admittedly, all of the charts like this that researchers have created show a relationship between inequality and immobility.

So Winship's argument is: "Any way you slice it, the data seem to support Krueger. But those data are noisy! Therefore Krueger is a liar!"

Refutation FAIL.

Winship's last substantive point is to attack Krueger's projections of future immobility:

There is one other big problem with [Krueger's figures]...particularly when a researcher is estimating future mobility, as Krueger did. If one believes that inequality diminishes opportunity, one should look at how inequality experienced in childhood affects mobility between childhood and adulthood. Krueger’s immobility data are, for the most part from people who were in their 30s during the 1990s, so they should be matched with inequality data from the 1960s, when those people were children. But instead they are matched with inequality data from 1985...

[A]ll of this means that Krueger’s prediction of immobility for “today’s children” is not so much a projection of what today’s children will experience as adults as it is an estimate of what today’s adults have already experienced.

This is just not right, for two reasons. Reason 1 is that inequality levels may be persistent. If inequality in 2011 predicts inequality in 2036, and if the contemporaneous correlation between inequality and immobility that was observed in 1990 continues to holds in 2036, then the rise in inequality from 1990 to 2011 predicts a rise in immobility from 2011 to 2036 (even if that rise has not yet made itself apparent in the 2011 immobility data!).

Reason 2 is that inequality may contain a persistent trend. If the rise in inequality from 1990 to 2011 predicts a similar rise from 2011 to 2036, and (again) if the Great Gatsby contemporaneous correlation holds, then we should expect to see much higher immobility by 2036.

So Winship's complaint - that the Great Gatsby curve measures a contemporaneous correlation - does not invalidate Krueger's warning of increased immobility. Ironically, there are some good arguments Winship could have trotted out against Krueger's immobility forecast - 1. correlation does not equal causation, and 2. the Great Gatsby curve could all be due to country fixed-effects, thus making longitudinal predictions invalid. However, for some reason, Winship does not choose to make these arguments, and instead relies on some very weak tea.

Winship concludes his article with some more concern-trolling:

[The Obama administration is] needlessly scaring the middle class into doubting their own security...So the president’s strategy is likely to hinder recovery from the Great Recession. In fact, there is reason to believe that Americans are more generous when they feel they are doing well than when they feel they are at risk, in which case the Administration’s strategy is doubly counterproductive if it wants to help the bottom.

Yeah, yeah. "Obama is slaughtering the economy with his socialist rhetoric, but really I'm only complaining because I care so much about helping the poor and disadvantaged." Gotcha.

But OK, let's back up. Winship called Alan Krueger "deceitful"! And nowhere in this article do I see anything even remotely resembling convincing evidence that this is true; instead I see a mix of value judgments and fallacious arguments. I say that if you are going to call someone a liar, you should back up your allegation really really well. Winship has not done this.

If I were Tyler Cowen, I would not have lavished such unqualified, effusive praise on this article.

Update: Winship responds to my point about the shrinking middle class by basically reiterating his point that if the middle class shrinks because people are moving to higher parts of the distribution, that's OK, because there's no downward mobility. He completely ignores my point that if the median is falling - if the middle class as a whole is getting poorer - then this does not seem very OK, even by his definition. As an example, consider a country in which everyone makes $10,000. In this country everyone is middle-class. Now suppose that two-thirds of the people see their incomes fall to $5000, while the rest are unchanged. The middle class, defined as median income +/- 50%, has shrunk, and it has happened without anyone moving to the lower extreme of the distribution. By Winship's definition, this constitutes "upward mobility". And has the median income been falling in the U.S., thus defining "middle class" downward? Yes. The median American household was about as rich in 2010 as it was in 1987, while working a lot more for that income.

Downward mobility refutation FAIL, and Krueger "deceitfulness" evidence FAIL.

Does mercantilism "work"?

2012-01-18T17:09:00.008-05:00

I recently had a Twitter conversation with ~~(probably) Karl Smith~~ Adam Ozimek (who shares a Twitter account with his co-bloggers), about whether or not mercantilism - export subsidies and import protection - is ever sound policy. ~~Probably-Karl~~ Adam's answer was "No." In giving this answer, ~~probably-Karl~~ Adam has the vast bulk of the economics profession behind him; in fact, it is often said that free trade is the only area of policy where economists agree. Naturally, this means that I must quixotically attempt to challenge the conventional wisdom.

In defense of the "free trade is always good" proposition, ~~probably-Karl~~ Adam directs me to this Brad DeLong post from 2007, in which DeLong referees an exchange between Dani Rodrik and Don Boudreaux:

In the ring, Dani Rodrik stumbles into a knockout punch from Don Boudreaux:

Don Boudreaux:

...If it's true that theory and evidence in favor of protectionism are sufficiently strong to warrant economists abandoning their conclusion that free-trade policy is generally sound, then why shouldn't economists -- led by Dani Rodrik -- also start exploring the potential benefits of intra-national protectionism? Surely a scholar not benighted with the free-trade "faith" ought to take seriously the possibility that, say, Tennesseeans could be made wealthier if their government in Nashville restricts their ability to trade with people in Kentucky, Texas, Rhode Island, and other states?...

I suspect that if someone proposed to Dani Rodrik that he explore the wealth-creating potential of state-level protectionism, he would refuse. He would likely (and correctly) say that it's ridiculous on its face to suppose that such protectionism would make the people of Tennessee as a group wealthier over time...

I score this for Don: a knockout.

So in order to defend the hypothesis that mercantilism might be sound policy, I must attempt to smack down Brad DeLong (always a dangerous endeavor). Very clever, ~~probably-Karl~~ Adam..So be it. I will attempt to smack down Brad DeLong.

The argument that Boudreaux uses is this: "If mercantilism is good policy at the nation level, why isn't it good policy at the U.S. state level?" DeLong finds this argument convincing. I do not, because I think it conflates two very different notions of what "good policy" means.

Suppose that trade policy is like a Prisoner's Dilemma game between two countries, where "cooperating" represents free trade and "defecting" represents mercantilism. The outcome that maximizes the total payoff - the Pareto optimal outcome - is for both countries to adopt free trade. But mercantilism is a dominant strategy.

Applying this conjecture to the case of U.S. states, there is a federal government that explicitly disallows states from pursuing most mercantilist policies (export subsidies, import taxes, etc.), thus forcing the Pareto-optimal outcome. But there is no world government, so nations should be mercantilist, since it is rational to play dominant strategies. As a result, in this conjectured world, it is perfectly reasonable to disallow mercantilist policy at the state level while pursuing it at the national level. Thus, DeLong and Boudreaux's point does not seem obviously right to me, since there may be strategic aspects to international trade.

Now, you may ask, in what model would trade policy really be a Prisoner's Dilemma? Well, I can think of one off of the top of my head - the New Economic Geography, my favorite development theory. In the international-trade version of this theory, countries undergo development one by one, not all at the same time. Beginning a development explosion requires investment from developed nations. Thus, whichever country with the lowest unit labor costs in the exportable goods sector (net of transport costs) will be the first to develop. In this world, undeveloped countries can compete to be the next country to develop, by subsidizing their exports (even though this subsidy can create a global inefficiency). Trade policy is a Prisoner's Dilemma between undeveloped nations.

I am not claiming that this is the world in which we live (but it might be!). I am simply making a point: Just because a world of free trade is the best possible world doesn't mean that free trade policy is always optimal for a country to adopt. I have not made an airtight case for mercantilism in this post, but I think I've addressed one of the main arguments against it.

Filling a hole or priming the pump?

2012-01-17T23:46:00.006-05:00

Who knew that neoclassical economists had something perspicacious to add to the stimulus debate? Steve Williamson sends me to this AEA talk by Jim Bullard of the St. Louis Fed. The presentation is mostly a rebuttal of the common liquidity-trap arguments for stimulus, but at the end, there was this one really interesting slide:

An alternative theory
An alternative theory is much less studied but closer to the rhetoric on fiscal policy effectiveness.
Suppose two regimes exist, one involving high growth and the other involving low growth.
Heavy government borrowing might signal that the high growth regime is likely; this might then influence private sector expectations and private sector decisions.
The high growth equilibrium could be encouraged as a self-fulfilling prophecy.
However, if government spending is viewed as wasteful, the private sector could coordinate on low growth.

Williamson adds:

As Bullard states, the type of coordination failure that some Keynesians appear to have in mind - self-fulfilling beliefs about the future driven by fiscal policy - has not really been formally studied.

Verrrrrrry interesting. Bullard is saying "All you Keynesians are bending over backward trying to make stimulus all about countering a shock to Aggregate Demand, when actually you have a mental model of an economy riddled with coordination failures and multiple equilibria, where stimulus is all about expectations."

I think he might be right about that.

To me it seems obvious that a recession is a coordination failure. There are all these unused workers sitting around wishing they had jobs, and all this capital sitting around not being used! Even if you are believe a "recalculation" story, in which recessions are the sluggish response of a complex system to a structural shock, there is no guarantee that the adjustment proceeds at the fastest possible rate. Basically, unused capacity means we are not making as much stuff as we could be.

Now, the commonly used Keynesian models do involve some kind of coordination failure. In the classic Keynesian Cross model, buyers and sellers fail to coordinate their plans, resulting in an inefficient buildup of inventories. In modern New Keynesian models, sellers (including workers) fail to coordinate their price changes, resulting in too-high wages and unemployment. In both of these models, fiscal stimulus works - if it works - by "filling the hole" in aggregate demand.

But the thing is, both of these models are short-term models. The Keynesian Cross offers only a very short window for stimulus to work, since inventories typically get run down in a few months. In New Keynesian models, prices adjust over a period of perhaps a couple years. If Congress doesn't "fill the hole" in AD, the hole will fill itself. That is because both of these models are single-equilibrium models - for a given fiscal policy, there is one level of output and prices to which the economy must move.

In a world with multiple equilibria, however, there is no such certainty. In a world of multiple equilibria, different initial conditions can have devastating and persistent effects on the economy. That is a world of lost decades, debt overhangs, self-fulfilling pessimism, and "sunspots." In that world, fiscal policy may not be important only in the short term, but in the medium or even long term. That is scary, given how uncertain and slow and inefficient the political process can be. But it is also optimistic in a way, since a relatively small stimulus might be able to nudge the economy from a bad equilibrium to a good one, thus "priming the pump" rather than "filling the hole".

Bullard and Williamson say that this is the type of model that modern supporters of fiscal stimulus really have in mind. I don't know to what degree that is true. It certainly is true that Keynesians and others have spent some time and effort trying to construct multiple-equilibrium theories to explain why fiscal policy seems to make a difference. And it certainly is true that the often-used metaphor of "priming the pump" invokes a multiple-equilibrium situation. For my part, I find it much easier to believe in a world of multiple equilibria, for reasons both theoretical and anecdotal. I even have some conjectures about what kind of equilibria those might be, though that is the subject for another post.

So should we be focusing on building multiple-equilibrium models in order to evaluate fiscal policy? In practice, it's hellishly hard to make those models both tractable and predictive (especially when forced to work in a clunky DSGE framework!). That is probably why stimulus advocates have used New Keynesian models with liquidity traps to make their case in intellectual circles. But progress is being made on the multiple-equilibrium front ~~- for an example, see this recent paper by Angeletos and La'O (about which I also intend to blog more)~~.(Update: Whoops! Wrong paper...thanks to Steve Williamson in the comments for pointing that out!). For some examples, see various work by Roger Farmer. I say that this is a very important direction for research.

It also means that we shouldn't assume that fiscal policy questions will simply become moot as time goes on. Depending on the type of equilibria the economy faces, stimulus may not only be a policy for the short term. It's interesting that neoclassical economists are the ones bringing attention to this idea.

Update: In the comments, Roger Farmer adds so much information about his work on multiple-equilibrium coordination-failure models that his comment is substantially more interesting than my entire blog post. Hence, I will post the comment here in its entirety:

Thanks for drawing attention to co-ordination failure models Noah. Let me clarify a couple of points about how my views differ from those of the new-Keynesians.

First; as you point out in your post, I have been working on a new generation of co-ordination failure models in which a high unemployment equilibrium can persist forever. The clearest exposition of these models is here

http://www.rogerfarmer.com/NewWeb/PdfFiles/fa-con-cra.pdf

I call these, second generation coordination failure models. They are different from the first generation models that Stephen refers to (for example, Farmer-Guo (1994) JET). First generation co-ordination failure models have multiple non-stationary equilibrium paths all converging to the same steady state. Second generation models have multiple steady state equilibria. This is a significant difference since first generation models, like new-Keynesian and classical models, cannot account for persistent high unemployment. Second generation models can.

Second; Steve is correct that I am reluctant to support large fiscal stimulus programs. I have written two papers on the role of fiscal stimulus in second-generation co-ordination failure models, one in an overlapping generations model here

http://www.rogerfarmer.com/NewWeb/PdfFiles/Farmer_Roger_Carnegie.pdf

and a second paper joint with Dmitry Plotnikov, in a representative agent framework here

http://www.rogerfarmer.com/NewWeb/PdfFiles/Farmer-Plotnikov.pdf

In both of these models, a fiscal stimulus will decrease unemployment. But if confidence remains low, the fix will be temporary. In both models, the fiscal stimulus reduces welfare because it crowds out private consumption.

Recall that in Keynesian models, increased government expenditure is supposed to "crowd in" private consumption. That is the whole idea behind the consumption-income multiplier. My reading of the evidence is that "crowding in" (an increase in consumption caused by an increase in government purchases) is not supported by the data.

If fiscal stimulus is to have a permanent effect in the models I work with, it must work through a non-economic mechanism. One channel would be a temporary boost to employment that restores the confidence of the private sector by influencing market psychology: A confidence booster. That is a possibility. But I think it is implausible that increased government expenditure will have that effect.

My reading of the evidence is that consumption depends primarily on wealth rather than income. That was the lesson of work by Ando and Modigliani, Modigliani, and Friedman in the 1950s. It is for that reason that I support interventions in the asset markets that try to jump-start the economy and reduce unemployment by boosting private wealth. That, in my view, is what quantitative easing has done.

A standard Republican narrative of history

2012-01-16T17:10:00.003-05:00

John Cochrane has a new post up in which he discusses the historical importance of Milton Friedman's book Free to Choose (a book I have never read. The first half of the post is a discussion of the difference between negative and positive rights, with which I largely (but not completely) agree. But the second half consists of a reading of events since 1980 with which I take a number of exceptions:

Here are a few "freedom, democracy and prosperity" events...since 1980:
The Reagan and Thatcher revolutions, including deregulation, tax reform, victory over inflation and inauguration of a 20-year economic boom.
A billion Chinese released from abject poverty. (Hint to China: read Capitalism and Freedom next.)
A billion Indians, also starting to join the modern world, having begun to overturn their Keynesian / English-socialist model.
We won the cold war. East and West Germany reunited. Eastern Europe freed.
The number of democracies, for example as scored by Polity, doubled since 1980. Many in Latin America and Africa too.
1980...was an end to US and UK inflation -- the result of mindless "stimulus" -- and the end of widespread acceptance of simpleminded Keynesian economics. It was the end of a brief interlude of unquestioning belief in the power of the Federal Government to solve all problems. It was the end of stagnation in the US and UK.

1980 was an inflection point for the advance of freedom, not its end! Yes, some of the Friedmans' dark worries did not pan out. Why not? Because people read the book! The Friedmans were fighting against the "tide of history." And turned it back....

We have a long way to go, and we've been heading backwards in the last few years, on all indices of economic and political freedom. Our 30 years of liberalizations may indeed now be coming to an end. The economic and political ills of the 1970s seem to be returning.

This appears to me to be a very standard intellectual Republican narrative of recent history; if you surveyed registered Republicans with postgraduate degrees, and then took an average of their responses, it seems like you might get something like this. Now, standard narratives are not necessarily wrong. But this narrative happens to be one about which my feelings are quite mixed.

I agree with a number of Cochrane's points. I agree about China. I basically agree about India (though where did Keynes support a "license raj"??). I agree about the Cold War and the spread of democracy. I agree about inflation. None of these positive developments should be forgotten or ignored.

But there are some points with which I strongly disagree. Let me address these:

1. "[1980] was the end of stagnation in the US and UK." What? Really?? What about the Bush years? You know, the 8 years when the inflation-adjusted stock market did worse than in the 1970s, income stagnated, and GDP growth underperformed past booms, all despite massive tax cuts and substantial deregulation?

2. "The economic and political ills of the 1970s seem to be returning." Really? Inflation?? No. I know there are some people who believe that a fiscally induced hyperinflation is just around the corner, but that is pure speculation...

3. "US and UK inflation -- the result of mindless "stimulus"" Really?? But budget deficits were low in the 1970s, and only exploded in the Reagan years (and again in the Bush years). And most economists believe that the 70s inflation was caused by loose monetary policy (and possibly oil shocks), not by fiscal policy.

Basically, in 2000, this Republican narrative was looking pretty good - though not entirely thanks to Republicans. Bill Clinton seemed to have proven that market liberalism did not require exploding deficits and exploding inequality (the ills of the Reagan years) in order to create prosperity. But then came the Bush years, and America doubled down on the Milton Friedman program with more tax cuts, more deregulation, more privatization. And income stagnated, stocks stagnated, and growth was lackluster, while debt and inequality resumed the explosive growth of the Reagan years. By the eve of the financial crisis, the Republican narrative was looking pretty shopworn.

I did not live through the 70s (and was a little kid in the 80s). My generation has seen all of the results of the Milton Friedman revolution, both good and bad. But we missed the revolution itself. The sense of idealism, promise, and heroism that some older intellectuals seem to feel when they recall that revolution is just a little alien to me. I like to think that this makes my generation a little more dispassionate when it comes to evaluating how it all turned out.

Seven principles for arguing with economists

2012-01-15T23:02:00.005-05:00

In the increasingly contentious world of pop economics, you - whether an educated layperson, an economist-in-training, or even a professional economist unused to the rough-and-tumble of the mediasphere - may find yourself in an argument with an economist. And when this happens, you should be prepared, because many of the arguments that may seem at first blush to be very powerful and devastating are, in fact, pretty weak tea.

For this reason, I have constructed a short list of (a few of) the fallacious arguments that you may encounter in your travels, along with suggested responses. Remember, forewarned is forearmed! I give you:

Noah's First Seven Principles For Arguing With Economists

Principle 1: Credentials are not an argument.

Example: "You say Theory X is wrong...but don't you know that Theory X is supported by Nobel Prize winners A, B, and C, not to mention famous and distinguished professors D, E, F, G, and H?"

Suggested Retort: Loud, barking laughter.

Alternative Suggested Retort: "Richard Feynman said that 'Science is the belief in the ignorance of experts.' And you're not going to argue with HIM, are you?"

Reason You're Right: Credentials? Gimme a break. Nobody accepts received wisdom from sages these days. Show me the argument!

Principle #2: "All theories are wrong" is false.

Example: "Sure, Theory X fails to forecast any variable of interest or match important features of the data. But don't you know that all models are wrong? I mean, look at Newton's Laws...THOSE ended up turning out to be wrong, ha ha ha."

Suggested Retort: Empty an entire can of Silly String onto anyone who says this. (I carry Silly String expressly for this purpose.)

Alternative Suggested Retort: "Yeah, well, when your theory is anywhere near as useful as Newton's Laws, come back and see me, K?"

Reason You're Right: To say models are "wrong" is fatuous semantics; philosophically, models can only have degrees of predictive power within domains of validity. Newton's Laws are only "wrong" if you are studying something very small or moving very fast. For most everyday applications, Newton's Laws are very, very right.

Principle 3: "We have theories for that" is not good enough.

Example: "How can you say that macroeconomists have ignored Phenomenon X? We have theories in which X plays a role! Several, in fact!"

Suggested Retort: "Then how come no one was paying attention to those theories before Phenomenon X emerged and slapped us upside the head?"

Reason You're Right: Actually, there are two reasons. Reason 1 is that it is possible to make many models to describe any phenomenon, and thus there is no guarantee that Phenomenon X is correctly described by Theory Y rather than some other theory, unless there is good solid empirical evidence that Theory Y is right, in which case economists should be paying more a lot attention to Theory Y. Reason 2 is that if the profession doesn't have a good way to choose which theories to apply and when, then simply having a bunch of theories sitting around gathering dust is a little pointless.

Principle 4: Argument by accounting identity almost never works.

Example: "But your theory is wrong, because Y = C + I + G!"

Suggested Retort: "If my theory violates an accounting identity, wouldn't people have noticed that before? Wouldn't this fact be common knowledge?"

Reason You're Right: Accounting identities are mostly just definitions. Very rarely do definitions tell us anything useful about the behavior of variables in the real world. The only exception is when you have a very good understanding of the behavior of all but one of the variables in an accounting identity, in which case the accounting identity acts like a budget constraint. But that is a very rare situation indeed.

Principle 5: The Efficient Markets Hypothesis does not automatically render all models useless.

Example: "But if your model could predict financial crises, then people could use it to conduct a riskless arbitrage; therefore, by the EMH, your model cannot predict financial crises."

Suggested Retort: "By your logic, astrophysics can never predict when an asteroid is going to hit the Earth."

Reason You're Right: Conditional predictions are different than unconditional predictions. A macro model that is useful for making policy will not say "Tomorrow X will happen." It will say "Tomorrow X will happen unless you do something to stop it." If policy is taken to be exogenous to a model (a "shock"), then the EMH does not say anything about whether you can see an event coming and do something about it.

Principle 6: Models that only fit one piece of the data are not very good models.

Example: "Sure, this model doesn't fit facts A, B, and C, but it does fit fact D, and therefore it is a 'laboratory' that we can use to study the impact of changes in the factors that affect D."

Suggested Retort: "Nope!"

Reason You're Right: Suppose you make a different model to fit each phenomenon. Only if all your models don't interact will you be able to use each different model to study its own phenomenon. And this is highly unlikely to happen. Also, it's generally pretty easy to make a large number of different models that fit any one given fact, but very hard to make models that fit a whole bunch of facts at once. For these reasons, many philosophers of science claim that science theories should explain a whole bunch of phenomena in terms of some smaller, simpler subset of underlying phenomena. Or, in other words, wrong theories are wrong.

Principle 7: The message is not the messenger.

Example: "Well, that argument is being made by Person X, who is obviously just angry/a political hack/ignorant/not a real economist/a commie/stupid/corrupt."

Suggested Retort: "Well, now it's me making the argument! So what are you going to say about me?"

Reason You're Right: This should be fairly obvious, but people seem to forget it. Even angry hackish ignorant stupid communist corrupt non-economists can make good cogent correct arguments (or, at least, repeat them from some more reputable source!). Arguments should be argued on the merits. This is the converse of Principle 1.

There are, of course, a lot more principles than these, and I'll include some in a later post. The set of silly things that people can and will say to try to beat an interlocutor down is, well, very large. But I think these seven principles will guard you against much of the worst of the silliness. Keep them always with you at your side...Happy arguing!

Welcome, economist, to the desert of the real

2012-01-11T14:28:00.009-05:00

One more post before I stop my unprecedented blogging frenzy. I'll make it a philosophy-of-science one.

Back in September, Frances Woolley of Worthwhile Canadian Initiative wrote one of the most telling posts I've ever read on the culture of the econ profession:

Economists like to begin with a general model, work out its implications, and then go to the data to test the theory...facts in and of themselves are uninteresting unless they illuminate economists' view of the world, and can be explained in economic language.

Psychologists begin by observing people's behaviour, looking for generalizable patterns...Yes, psychologists have conceptual explanatory frameworks, such as prospect theory, to explain such phenomena,but these theories are not the elegant mathematical creations favoured by economists...

It's a dilemma for behavioural economists. Yes, it's possible to go into the lab or into the field, run experiments, and see how people actually behave...But what do you do next?...

[I]f people's demands are just a product of framing, salience, [etc.], how can we...make any inferences about the efficiency of different [policies]?

The economic approach to policy analysis is deductive - economists begin with assumptions about consumers' and firms' preferences and behaviour...Perhaps there is some way of including behavioural considerations into that framework...But that doesn't feel right to me - if a consumer's marginal benefit from consumption is something other than what is revealed by his or her demand I could just make up anything as a marginal benefit curve, and economics would become a completely ad hoc exercise.

Dabbling in economic psychology or behavioural economics is a little like taking the red pill - you go down the rabbit hole, and wake up realizing that the entire world is an illusion.

How can economists evaluate policy if they can't use people's preferences as revealed by their choices? We still need some way of figuring out which policies help people and which policies hurt people...

Once you fall down the rabbit hole, you just have to keep on going. If people's choices are not a reliable guide to their well-being, you have to turn to something else. Ask people how happy they are and measure well-being in terms of happiness. Evaluate health care spending by looking at objective measures of health, such as mortality, morbidity, or survival rates. Chuck out the entire elegant theoretical framework of welfare economics.

That idea has me, for one, reaching for the blue pill - after all, people aren't stupid, so standard economic analysis isn't a bad approximation of the real world, is it?

But I can't find one. I can't get all of that behavioural stuff outside of my head.

This post is an absolutely wonderful window into the world of the economist's mind. I'll talk about what it means for the profession in a moment, but first let me do the philosophy-of-science bit.

Science proceeds through a reciprocal process of deduction and induction. You look at the world, you try to make sense of what's going on, then you look at the world some more to see if you really managed to make sense of it. And you just keep repeating that.

It doesn't really matter whether you start with deduction or induction. If you start with a theory that you just made up because it sounded reasonable, that's fine! You just have to go test it before you believe it. If you start with some observations, that's fine too...you just have to try to make a theory to make sense of them, or your observations will not allow you to make inferences from what you observed. And making inferences - i.e., increasing humanity's power to control our Universe - is what science is really all about.

If your science is only "deductive" or only "inductive," what it really means is that you are stuck. You can't get to the next step. Either you don't have theories that match the data, or you have observations you can't explain. That's fine. Getting stuck happens all the time; you just have to recognize it and keep trying, and then maybe someday you'll get unstuck, and that's called a scientific revolution.

What you don't want to do is accept being stuck. There is a temptation for a scientist to try to convince herself that her field doesn't need one of the two steps - to say "My field is an inductive science, we don't need theories," or "My field is a deductive science, we don't need to test our theories." If a field as a whole accepts one of these seductive errors, it can stagnate for long periods of time. Some people argue that psychology is stagnating by ignoring the need for theory. Others argue that particle physics is stagnating by ignoring the need to test string theory.

At least since Kahneman started doing economics experiments back in the 70s, people have been arguing that economics has stagnated by not paying enough attention to the real world - by valuing theories that seem intuitive, or tell a good story, so highly that we refuse to admit any evidence to the contrary. Behavioral economics is a response to that criticism, as is the increased focus on natural experiments.

This has been a good development. But the battle for more attention to evidence is still an uphill one, as Woolley's post demonstrates. The profession as a whole is very enamored with the elegance of certain foundational ideas - revealed preference, Von Neumann-Morganstern expected utility, the First and Second Welfare Theorems, Arrow-Debreu equilibrium, etc. And for a long time, economists were not held to the same standards as natural scientists - we didn't have to prove our theories. Our field grew out of a literary tradition, not an engineering tradition. Smith and Hume were brilliant people, but folks in those days didn't read their books and go "Oh yeah? Well, prove it!"

And so we got spoiled. With no one forcing us to move on from deduction to induction, we were able to shy away from the cold, bitter snowstorm of reality, slam our doors, and simply choose to keep believing in things that sounded good to us. You can see the remnant of this longing in Woolley's desire to "reach for the blue pill" - instinctively, she doesn't want behavioral results to be right, she feels a primal urge to huddle close to the warm fire of classical theory.

But in the end, she can't. As our society became more scientifically oriented, the literary tradition in economics died out - a process that was aided, ironically, by the mathematics that made the foundational results of classical theory so elegant and beautiful. When you make quantitative arguments, eventually people are going to ask where they can find those quantities in the real world. The door to reality has been wedged open, and snow is pouring in. That's why Woolley can't bring herself to "take the blue pill" - for better or worse, we're scientists now, not philosophers.

The only hope for our science - for any science - is to keep alternating between deduction and induction, no matter how long each switch may take. For microeconomics, the challenge is to get a more complete picture of both human behavior and the effects of markets, and to craft coherent theories that make sense of that picture. This effort precedes apace. (As just one example, check out this paper by Dan Benjamin, Matt Rabin, and Collin Raymond, which integrates a bunch of behavioral anomalies into one interesting theory.)

For macro, though, I fear that many of us are still telling ourselves that deduction is all we need - that we should keep putting "theory ahead of measurement," that we should continue to believe in theories after the data has rejected them. That needs to stop, or we'll never get anywhere. I like to think that the awarding of last year's Nobel prizes to two macro empiricists - one who created an alternative to DSGE, and one who rejected a ton of rational-expectations models - is a sign that other people have realized this as well. But it's going to be an even more uphill battle than in micro. Macro has much worse data, after all. It's almost certain that, unlike in micro - where additions like Prospect Theory often represent only moderate tweaks to existing frameworks - most or all of our existing macro theories will turn out to be not even close to right. But we have no choice but to reject those models, or we will eventually fade into noodling irrelevance.

Welcome, economist, to the desert of the real.

(It's, you know, a snowy desert. Like Antarctica.)

Japan had one lost decade, but not two

2012-01-10T14:33:00.004-05:00

Matt Yglesias thinks that Japan did indeed have two lost decades (1990-2007). But I disagree with the arguments he makes. I believe that 2002-2007 were good years for Japan.

First of all, Matt cites the fact that Japan's employment-to-population ratio fell steadily from 1990. However, this must be weighed against the fact that Japan is aging extremely rapidly. In particular, the retirement of Japan's baby boomers began in 2005, since the retirement age for many Japanese workers is 60, not 65 as in the U.S.

Next, Matt cites a fall in Japan's hours worked per employed person, from about 2,100 in the late 80s to about 1,750 in the late 2000s. However, a reduction in hours worked can be part of a long-term trend toward more leisure. In fact, as Matt himself pointed out in a post about the Great Depression, the U.S. experienced a long-term fall in hours worked during the period from 1920 to 1980, most of which were good years economically:

(Note that this graph shows something slightly different than the graph Matt shows for Japan, so the levels can't be directly compared.)

In fact, given Japan's legendary culture of overwork, a fall in hours - if it is real, and not simply a reflection of an uptrend in unpaid, unreported overtime - is probably a good thing.

The fact is, despite the trends that Matt cites, Japan's real per capita GDP growth did slightly better than that of the U.S. (and about as well as Europe) during the period from 2000-2007:

Paul Krugman also points this out. Actually, I lived in Japan in 2004 and 2005, and I remember how well everyone said the economy was doing (including the econ professor I worked for).

If Japan had a "lost decade" in the 2000s, then the whole developed world had one as well. And given the variety of policies being enacted around the world (historically low interest rates and high budget deficits in the U.S., for example), it seems a bit of a stretch to conclude that the whole world suffered a simultaneous lost decade resulting from a simultaneous policy mistake that led to a worldwide aggregate demand deficiency. (Not that AD wasn't an issue in Japan; in fact, Japan's period of robust growth in the mid-2000s followed a policy of quantitative easing and an uptick in inflation.)

So I agree with Krugman. Japan had one lost decade (the 90s), but not two.

Update: Krugman also argues that Japan could have done a lot more and recovered a lot faster than it did. I agree with that. But I think that the success of the Koizumi years (early- and mid-2000s) should not be ignored, since it represents probably the best policy experiment we have regarding the effectiveness of quantitative easing.

Update 2: More on the subject, from CEPR. It seems that Japanese productivity growth outpaced America's from 1990-2007! Wow, I hadn't known that! How people can see numbers like that and still believe that economic stagnation is caused by technology shocks is beyond me...

The new ethics rules won't hurt and might even help

2012-01-10T14:30:00.000-05:00

I was busy interviewing for jobs at the AEA Meeting this past weekend, so I missed lots of cool stuff (including the apparent hijacking of the blogging panel by an angry undergrad!). Among the things I missed, the new code of ethics for publishing in economics was almost certainly the most important. Basically, when you publish a paper in an AEA journal, you must now disclose A) all significant sources of financing for the research, and B) all significant financial relationships with parties who might have an interest in the research. These requirements are similar to what researchers face when publishing in medical journals.

The new guidelines are an attempt to counter allegations that the economics profession has been "captured" by various special interests. The idea is that if people see that an economist who publishes a paper supporting policy X is also being paid by a company or foundation with an interest in seeing policy X enacted, then people will be more likely to take the paper's recommendations with a grain of salt. This, it is thought, could lead to better policy, by preventing special interests from being able to essentially buy peer-reviewed academic articles to bolster their lobbying efforts.

Will these guidelines improve policy? Some are skeptical. There is a real question of how important peer-reviewed articles are to actual policymaking; after all, a lobbyist can cite a white paper from a think tank like the Heritage Foundation more easily than it can cite a dense, math-filled Econometrica paper. On the other hand, peer-reviewed journal articles may have a more subtle influence, spread out over a longer period of time - Keynes' "slaves of some defunct economist" idea.

But I think the important question is: Will the new guidelines hurt anything? I can't see any way that they could. To argue that the rules will make us worse off, you basically have to argue that more information will make the marketplace of ideas less efficient. I guess that's a possible argument to make, but it seems kind of unintuitive. In general, it seems to me that more sunlight can't be a bad thing. And if a policy has potential benefits and no obvious downside, why not do it?

There are a few who disagree, of course. Tyler Cowen thinks that the new rules will backfire on the journals:

[The new code of ethics] will hurt researchers who work in finance...How many people will basically just stop publishing in the top journals?

That nearly made me laugh out loud. Stop publishing in the top journals?? Surely you're joking, Mr. Cowen...

Anyway, kudos to the AEA. They did the right thing.

Paul Krugman and the polemical style of blogging

2012-01-09T15:44:00.000-05:00

Just got back from the AEA Meeting, where I happened to run into a lot of cool bloggers, including Mark Thoma, Ryan Avent, Alex Tabarrok, Justin Wolfers, and Steve Landsburg. Unfortunately, I didn't get a chance to meet Paul Krugman.

Anyway, back to blogging! On the subject of Krugman, I've been wanting to write something about this Tyler Cowen post ever since I read it last week, but with job interviews coming up, I didn't have the time. So this post is a little late.

In his post, Cowen let loose with a broad criticism of Krugman's polemical blogging style:

Krugman a) regularly demonizes his opponents, including those who hold Krugman’s old positions, and b) doesn’t work very hard to produce the strongest possible case against his arguments...

Can you imagine the current Krugman writing something sufficiently multi-faceted that you might come away thinking — because of the piece itself — that the opposing point of view was the better one?...

Krugman has shown a remarkable and impressive capacity to reinvent himself, more than once. He could reinvent himself again [to be less one-sided] and become the most important American public intellectual — and perhaps intellectual — of his time. Or he could keep his current status as a sharp and brilliant someone who has an enormous number of followers but relatively little influence over actual events[.]

I don't know if I agree with this. Yes, Krugman writes in a polemical style. He mocks ideas that he thinks are nonsense, he accuses people of misunderstanding basic economics, and he occasionally accuses certain writers of dishonesty. Is this a bad thing?

I say: it depends on what the world needs right now.

I think you can approach an econ blog in one of two basic ways. Way #1 is to put your complete thought process on a page - to lay out both sides of an argument, and explain why you arrived at a conclusion. This is what Cowen calls the "Humean" method, after David Hume. As I see it, the Humean method is what you use if you want to get the most out of a discussion with a well-informed but fundamentally disinterested interlocutor. If your conclusion is right, then the Humean method is likely to convince such an interlocutor to reach the same conclusion. If your conclusion is wrong, it maximizes the chance that the well-informed but disinterested interlocutor will see where you went wrong and help you to correct your mistake.

But not all interlocutors are disinterested. Some have political agendas. Some have strong personal biases. And not all interlocutors are well-informed. So if one uses the Humean method of argumentation, it is quite possible that your carefully considered ideas will be opposed by a totally biased person who doesn't bother to be nearly as even-handed as you, because he just doesn't care. And this biased opponent may, through his vehemence and the artificial simplicity of his arguments, succeed in convincing many poorly-informed third party observers of his point of view, even if yours has the weight of logic and evidence behind it. And society may suffer as a result.

In this situation, it may provide the most social benefit to adopt a more Hegelian method of argumentation. Hegel's idea of how good conclusions are reached has been described as a process of "thesis, antithesis, synthesis" - two people argue their cases as strongly as possible, and observers can pick and choose the best points of each. This is how our court system works, for example. In the context of econ blogs, using a Hegelian approach means saying "My opponents are going to do everything they can to push their point of view, so I had better do the same in order to balance them out."

This seems to be what Krugman is doing. He writes:

I realized that I also wanted to say something in response to the concern trolling, the “if you were more moderate you’d have more influence” stuff. Again, this amounts to wishing that we lived in a different world. First, there is no such thing in modern America as a pundit respected by both sides. Second, there are people writing about economic issues who are a lot less confrontational than I am; how often do you hear about them? This is not a game, and it is also not a dinner party; you have to be clear and forceful to get heard at all.

In other words, he's adopting a polemic style as a Hegelian tactic, to balance out bad guys who pull no punches.

That's a pretty extreme tactic for an academic type to use. But I can understand why Krugman might use it. After all, he lived through the Bush years - he witnessed the power of loudly repeated lies to overcome even-handed reasonable argumentation, in the run-up to the Iraq War. It's hard to go through something like that, and, as a famous pundit, to think that just maybe you might have been able to stop the madness if you had been just a little more forceful and a little less "fair and balanced." It's less of a worry for me, but only because my audience is fairly limited.

Has Krugman's polemical style been self-defeating? Cowen claims that Krugman has "relatively little influence over actual events," but as evidence he cites only a link to an earlier post of his that asserts the same thing. I can see the case, of course. Krugman warned that Obama was too conservative during the 2008 primaries, but Obama won anyway. Krugman advocated bank nationalization, bigger fiscal stimulus, and a tougher policy toward China's exchange rate peg - all to no avail.

But does that mean Krugman has little influence? The idea of "Keynesian economics" has re-entered the mainstream non-economist public dialogue, largely thanks to Krugman. Fiscal stimulus, which was once advocated only in the middle of economic free-fall by technocrats like Larry Summers, has become a rallying cry for a large number of people who think policy should take a more active role. And, most of all, Krugman's assault on the macroeconomics profession itself has caused much of the public to turn on the practitioners of macro, spurring them to scramble for new ideas, new approaches, and new data.

You may think those results are good things, or not. But I think it's very hard to argue that Krugman has not been enormously influential. As to the question of whether he is the most important American public intellectual of our time...well, I'm having a hard time thinking of who else would fit that description.

Conservatism: Always at war with some part of America

2012-01-09T15:21:00.002-05:00

More catch-up blogging...I'm overdue for a broadside against the conservative movement, so here goes.

Many people think of the conservative movement as basically nationalist. Think of a guy with an American flag decal on his truck. But I guess I've always seen the American conservative movement in a very different light - as a factionalist movement, concerned more with the balance of power within America than the strength of the country overall. (Naturally, this paints the movement with too broad a brush, but we'll get to that.)

As examples, take George Will and Rick Santorum. Here's George Will, in a recent New York Post column:

Imagine what a horror 2011 was for progressives as Americans began to comprehend their stunning abundance of fossil fuels...environmentalism as the thin end of an enormous wedge of regulation and redistribution is a spent force...Meanwhile,...sales of the electric-powered Chevrolet Volt were falling short of General Motors’ goals even before reports about fire hazards in crash tests. A Wall Street Journal headline proclaimed: “Americans Embrace SUVs Again.”

Why is George Will saying that General Motors' loss is a good thing for America? You'd think that a patriotic conservative - not to mention one who stands behind the business community - would want to see an American company's investments pay off. But George Will is cheering the failure of the Chevrolet Volt.

The reason is that the failure of the Volt represents not just a loss for GM, but a loss of face for a subset of Americans whom Will despises: environmentalists, whom Will thinks are merely crypto-socialists. The success of a product whose benefit is energy efficiency would lend credence to the claim that energy constraints are real; hence, in Will's mind, it is a good thing for us to spend more on energy just to prove that we have energy to waste. For this type of conservative, the Good Americans are those associated with the energy industry, and the Bad Americans are environmentalist crypto-socialists.

Or take Rick Santorum's statement on blacks and welfare:

At a campaign stop in Sioux City, Iowa on Sunday, Republican presidential hopeful Rick Santorum singled out blacks as being recipients of assistance through federal benefit programs, telling a mostly-white audience he doesn’t want to “make black people’s lives better by giving them somebody else’s money.”

The idea that all government spending is racial redistribution is so common on the right, and so widely accepted, as to be almost not worth saying out loud. I can't tell you how many times I've encountered this idea in conversations with conservatives. And pretty much every conservative rant against government spending, in the popular press or in stump speeches, is a dog-whistle for this very idea. For this type of conservative, the Good Americans are hard-working whites and the Bad Americans are lazy blacks living off the government teat.

Of course, as an aside, both of these worldviews rely on claims for which there is little factual support. George Will cites the fact that America is now a net exporter of petroleum products, but that figure is for refined petroleum products only - if you include crude petroleum products, we still have a monster deficit. Closing our eyes and wishing really hard that we were Saudi Arabia is not, and will never be, a viable strategy for national prosperity. As for Santorum, he ignores the fact that a disproportionate number of the people on food stamps are white (84%, compared to about 80% of the populace).

Naturally, the facts are irrelevant to these factionalists. Factionalists imagine themselves to be part of a tribe, and tribal knowledge beats actual knowledge nearly every time.

I believe that this factionalism is hurting our nation, by paralyzing the political process and by reducing government investment to a below-optimal level. This is the main reason I am so strongly opposed to the American conservative movement. Naturally, liberals have been factionalist at times as well, but the strength of the conservative tribal consciousness - especially with regards to race and the "racial redistribution" worldview - is just much greater right now than anything on the left.

But there is hope. I've been reading articles by conservatives like Reihan Salam, Ramesh Ponnuru, and Peter Thiel that have a much more nationalist flavor, including greater support for government investment (and I've seen hints that Bill O'Reilly has started to think along these lines as well). Our current tendency toward factionalism grew out of the long period of peace and plenty between World War 2 and the Bush years, when the only real question was how to divide the American pie. With the lost decade(s) and the waning of American power, it's becoming more painfully clear to people on both the right and the left that factionalism is nothing more than a crippling distraction. But old habits die hard, and the poisonous notion of Good Americans vs. Bad Americans is still the right's dominant paradigm.

What are asset bubbles and why do they happen?

2012-01-04T15:36:00.003-05:00

Tomorrow I'm going to go the American Economic Association's annual meeting, to interview for economics jobs. (For the uninitiated, most jobs that are specifically for new econ PhDs conduct interviews at this meeting, which is what most economists mean when they talk about "the job market.") One of the key elements of getting a job as an economist is to have a "job market paper," which is generally the first chapter of your dissertation, and which is what shows potential employers that you can do quality research. My job market paper is here in case you want to read it. I'm not going to spend a heck of a lot of time discussing the paper (that can wait until it's ready to send off to journals), but it gives me an opportunity to write a post I've been wanting to write for a while anyway, about the research that motivated my paper in the first place.

That research is the Vernon Smith "bubble experiments." "Bubbles, Crashes, and Endogenous Expectations in Experimental Spot Asset Markets" (Smith, Suchanek and Williams, Econometrica 1988) is definitely a Paper You Should Know.

What is a "bubble"? Well, it's something that looks like this:

Prices go way up, then they crash back down. Look at any long-term plot of any asset price index (stocks, housing, etc.) and you're likely to see some big peaks like this. That's what I call a "bubble." It's also the definition used by Charles Kindleberger in his book Manias, Panics, and Crashes.

But the real question is why we care about bubbles. Some people believe that bubbles are merely responses to changes in expected fundamental value of an asset (the "fundamental value" is the expected present value of the income you get from owning an asset). According to this view, the NASDAQ bubble happened because people thought that internet companies were going to make lots and lots of profit, and when those expectations didn't materialize, prices went down again. This view is held by many eminent financial economists, including Eugene Fama, the most cited financial economist in the world.

If bubbles represent the best available estimate of fundamental values, then they aren't something we should try to stop. But many other people think that bubbles are something more sinister - large-scale departures of prices from the best available estimate of fundamentals. If bubbles really represent market inefficiencies on a vast scale, then there's a chance we could prevent or halt them, either through better design of financial markets, or by direct government intervention. For a discussion on theoretical reasons to believe or disbelieve that bubbles = departures from market efficiency, see this email exchange between Eugene Fama and Ivo Welch. Very good stuff.

But in the end, empirical reality has to have the last word. And here's the problem we run into when we try to answer the question by looking at the data: It's nearly impossible to know what fundamentals really are. So in 1988, Vernon Smith (now a Nobel laureate) had the idea of using lab experiments to study bubbles. In a lab experiment, the experimenter knows what the fundamental value is, so whether the price exceeds the fundamental can be known with a high degree of confidence.

So Vernon Smith and his co-authors put groups of subjects in a lab, gave them some cash, and let them buy and sell a computer-generated financial asset. The asset payed dividends to whoever held it, so its fundamental value was equal to the expected value of the dividends it paid (or less, since people might be risk-averse). So not only did the experimenters know the fundamental value of the asset, but the subjects themselves were told everything they needed to know to calculate the fundamental!

And guess what happened? Prices rose way above the fundamental value, and then crashed at the end of the market. Check out this graph of the prices from one of their experimental markets:

The black stair-step line is the fundamental value (it goes down, since the market has a fixed finite lifetime). The dots are prices at which subjects exchanged the asset. As you can see, prices went way above the expected value of the asset in periods 3 and 4, then crashed back down somewhere around periods 9 and 10.

You are looking at a bubble that is also a market inefficiency. It is real. It exists.

Now if we knew that the market in this lab experiment was the same as real-world financial markets, this graph would spell death for the Efficient Markets Hypothesis. Done. Kablooie.

But of course, we do not know that this market is the same as a real-world market. This market is 8 inexperienced college kids in a lab, trading about $200 worth of an asset that is very different from real-world assets, over a period of maybe an hour. Real-world markets are made up of thousands or millions of experienced traders trading trillions of dollars worth of assets, with plenty of time to make their decisions. In other words, the Smith, Suchanek, and Williams experiment does not instantly explode all of efficient-market financial economics, because it may lack external validity.

But if it does have external validity, it's the most important empirical result in all of financial economic history.

A lot of work has gone into figuring out whether the Smith-Suchanek-Williams result has external validity. On one hand, it's reliably true that when the same group of traders - or even part of the group - repeats the market 3 times in a row, there's no bubble. On the other hand, if you take those "experienced" traders and run the experiment with a different fundamental value process, the bubbles come back.

The Smith-Suchanek-Williams type experiment has been run with professional traders. It has been run with large numbers of traders. It has been run under various different market institutions - allowing short selling, using different kinds of markets, under various rules, etc. Always, the bubbles come back. As the list of "things that don't prevent lab bubbles" grows, so does the nagging feeling that this type of inefficient bubble may be a universal phenomenon.

But there is one critique of the Smith experiment that has never really been put to rest. What if subjects just fail to understand the fundamentals? Maybe subjects simply learn by doing. Maybe you can tell them the fundamentals, but they don't really understand and believe in the fundamentals until they've had some experience with seeing the dividends roll in. In fact, there is research to support this critique. For example, when you let the subjects watch the dividend process before they trade, or when you explain the fundamental value in a different way, the bubbles disappear.

Nobody is really interested in a bubble that only happens because subjects are confused. It's easy to confuse a bunch of college kids. So this critique has limited the degree to which the "bubble experiment" literature has turned the financial econ world upside down.

That's where my job market paper comes in, actually. My experiment was about determining demand for assets in experimental markets - i.e., figuring out why people buy assets, not just whether markets lead to bubbles. Instead of the normal market setup, where all the traders trade with each other, I had traders who simply watched the prices that were produced by such a market, and then let them trade at those prices without affecting the price (think of this as one guy sitting at home buying and selling on E*trade; he's too small to move the market, but we can learn a lot from watching how he makes his decisions).

And one of the things I did was to ask my subjects how much dividend income they thought they would get from holding a share of the asset (i.e., the fundamental value). So I was able to tell who understood the fundamental value and who didn't. So I could tell if people who understood the fundamentals would knowingly overpay for the asset.

And guess what? They did. Even people who understood exactly how much the asset was worth were overwhelmingly likely to pay, say, 60 yen for a share of the asset (the experiment was run in Japan), even when the most dividend income they could possibly get for it was only 40 yen. They gave up certain gains. (Why on Earth did they do this? Well, that's what the rest of the paper is about, and is a subject for at least two other long blog posts.) So this result really answers one critique of the Smith bubble experiments: understanding what's going on is not sufficient to make subjects act like the "rational arbitrageurs" in financial economics models.

Now, that's only one critique of bubble experiments. It's impossible to answer them all. But science is a process of excluding causes one by one. The more uninteresting causes of bubbles we exclude, the closer we get to finding whatever interesting causes may exist.

To sum up: If we believed that Vernon Smith type bubble experiments could reliably show us how real financial markets work, the finance industry would be falling over itself to do a billion lab experiments, and both business and government would have to seriously rethink policies that depend on markets being efficient (e.g., stock options for executives). But the jury is still out. Still, the bubble result of Smith, Suchanek, and Williams (1988) is one of the most important experimental findings in the history of economics, and a research effort to which I am happy to (attempt to) contribute.

Is debt a burden on future generations? It depends.

2012-01-01T23:53:00.004-05:00

Does government debt impose a burden on future generations? Paul Krugman says no. Nick Rowe says yes. But they're talking about different things.

Paul Krugman asks: If we wake up in 2012 and find ourselves with $9 trillion in government debt, are we any worse off than if we wake up and find ourselves with zero government debt? Assuming that all of our government debt is held domestically (so that we don't have to slave away for foreigners), and assuming that we don't default on our debt (which causes economic disruption), the answer is "no." Some people (creditors) are better off and some are worse off, but overall it's a wash.

Nick Rowe asks: If, starting now in 2012, we rack up some more debt over the next decade, will that make our descendants in 2042 worse off than they would be if we didn't rack up any more debt? Rowe's answer is "yes." To show how this works, Rowe makes an "overlapping generations" model where all goods are perishable and debt temporarily grows faster than GDP. In the model, the government uses debt to give extra consumption to the older generation, then taxes the younger generation to pay back the debt. Voila! A burden is imposed on the young.

But see, here's the interesting thing about Rowe's model: the government doesn't need to use debt to impose this burden on the young. It can achieve exactly the same result with zero debt, just by taxing the young directly and spending on the old (i.e. a Social Security system with unsustainably large contributions). In Rowe's model, debt is just an accounting system that keeps track of how much consumption has been transferred from the young to the old. But the debt itself doesn't really matter; only the consumption transfer matters.

So I think this tells us something important about debt in the real world. What matters is not debt, it's intertemporal choice. The important question is not how much debt we rack up, but whether we want to move consumption from the future into the present or from the present into the future.

In the real world, the way we move consumption around through time is through investment. In Nick Rowe's toy model there is no investment (because all consumption goods are perishable), but in the real world, the way we move consumption into the future is by investing in productive assets, like buildings or machines or education or ideas. The way we move consumption from the future to the present is by reducing investment and consuming more today.

So when the government takes out more debt, does it move consumption from the future to the present, or from the present to the future? The answer: It depends on what the government spends the money on!!!

("Aha!", you say at this point. "But investment = savings, and debt is negative saving, so more debt always means less investment!" And here is where I invoke Krugman: For the government to borrow money, someone has to save money by buying the government bonds. Objection overruled!)

It depends on what the government spends the money on. If the government borrows money and then invests it in productive assets - building or repairing infrastructure, researching new ideas, improving schools - and if those productive assets have real rates of return that exceed the rate at which the government borrowed, then the debt (or rather, the debt-financed spending) transferred consumption from us to our descendants, not the other way around. And note that this is true whether the government borrows domestically or from foreigners. But if the government spends the money on consumption - for example, buying everyone in the country a birthday cake - then the debt-financed spending has transferred consumption from our descendants to us...it has imposed a burden on future generations.

Now, it's also true that the private sector can act to neutralize some or all of this intergenerational consumption transfer. If increased public debt is spent on consumption goods (birthday cake), then the private sector can choose to invest more of its own money in productive assets (e.g. office buildings or trucks), thus negating the burden imposed on the future generations. To what degree that actually happens is an open question.

But the basic point is this: When asking whether running up our debt will impose a burden on future generations, the key question is what the government will do with the money it borrows. I personally believe that the U.S. is currently underinvesting in the kind of productive assets that only the government can cheaply create - roads, bridges, electrical grids, broadband infrastructure, and basic research. That means that if our government borrows to invest in those things, it will be doing our grandkids a favor, not imposing a burden.

Actually, I don't think David Romer is batty at all...

2012-01-01T16:57:00.004-05:00

Scott Sumner thinks I am too quick to bash other people's blog posts without first doing my due diligence:

Noah Smith is a very smart guy, but he has a bad habit of jumping into disputes without first discovering what the other side is actually saying. Indeed he recently admitted this after DeLong pointed out that his criticism of Robert Lucas was inaccurate.

Guilty as charged (though readers should note that said mistake was more of an attempt to defend Lucas than criticize him). The blogosphere is a place where we discuss very high-level ideas in very glib sentences, and whenever high-level ideas are discussed in very glib sentences, there will be a tendency to misinterpret people's claims. So a lot of these arguments are really just people talking past each other, which is kind of a waste of time. Like most econ bloggers, I engage in that sort of thing more than I should.

Sumner, who is an even smarter guy than I am, believes I have made another such error in this post of mine. He writes:

In his long post he spends a lot of time setting up foolish arguments that he imagines I might make, and then shoots them down. Unfortunately for him, I don’t actually make those foolish arguments.

Well, perhaps I did. Let's see what I said in my earlier post. I was responding to this quote of Sumner's:

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

Now, I do admit that this sentence could mean several things! Let's consider three claims that could be represented by this statement:

Possible Claim 1: Because monetary policy can act in opposition to fiscal policy, the effect of fiscal stimulus depends crucially on how the Fed reacts to a stimulus.

Possible Claim 2: The data show that, in practice, the Fed does act to negate the effects of fiscal stimulus.

Possible Claim 3: Because the Fed can, in theory, counteract any fiscal stimulus, the effect of any fiscal policy on output should be considered to be zero.

So, let's look at these possible claims. Possible Claim 1 is a theoretical claim. It basically just says that monetary policy is always capable of counteracting fiscal policy. That claim is not logically inconsistent ("batty") at all. Arguable, maybe - since it depends on how effective you think monetary policy can be - but certainly not batty.

Possible Claim 2 is an empirical claim. Therefore, it can't be logically inconsistent or "batty"; only the data will tell us if it's true or not. Andy Harless and David Beckworth argued in the comment thread of my earlier post that this claim is true, and I'm certainly willing to entertain the possibility that it is true (though I must say I am skeptical).

Possible Claim 3 has two parts - a definitional part, and a theoretical part. First, it says that (3a) when we talk about the "multiplier" associated with fiscal stimulus, we should include the Fed's reaction function in the model that we use to estimate the multiplier. This is the argument made by David Romer in some remarks cited by Sumner:

As Robert Solow stresses in his remarks in this session, we should not be trying to find “the” multiplier: the effects of fiscal policy are highly regime dependent. One critical issue is the monetary regime...if [central banks are] successful [at offsetting the effects of fiscal policy], one would expect the estimated effects of fiscal policy to be close to zero.

This is just saying that there are several ways to define "the multiplier" - you can talk about the multiplier while holding monetary policy constant, or you can talk about the multiplier in the context of a model that includes the Fed's reaction function. If we look in the data and see that a fiscal stimulus was followed by an increase in nominal output, we could say that "The stimulus increased output," or we could say that "The Fed increased output by choosing not to counteract the stimulus." To borrow an old NRA slogan, it's a question of whether guns kill people or people kill people.

BUT, aha! Possible Claim 3 also involves a theoretical claim. This is the claim that (3b) the Fed's reaction function is invariant to fiscal policy! To see why, consider a world in which the Fed targets a 3% growth rate for NGDP if there is no stimulus, but raises the growth rate target in the event of a stimulus. In this case, it would make perfect sense to say "fiscal stimulus increased NGDP growth," in the sense that we normally think of causality. It would make no sense to attribute the growth increase to the Fed. That would be like saying "You think you put butter on that piece of toast, but actually it was I who put butter on that piece of toast, since I could have clobbered you on the head and stopped you from putting butter on the toast, and I chose not to. Thus, you are incapable of buttering toast; only I can butter your toast." That would be a truly batty claim!

And it was this claim, Possible Claim 3, that I believed Sumner to be making. Which is why I said it was "batty."

Now, maybe I was wrong. Maybe I misunderstood what Sumner was trying to say when he said "the fiscal multiplier is roughly zero because the Fed steers the (nominal) economy." When I go back and read that sentence again, it still sounds like Claim 3b, but that could be my minsinterpretation. Perhaps Sumner was only making a combination of Possible Claims 1, 2, and 3a. Perhaps he was saying that in the past, the Fed has counteracted fiscal policy, and can therefore be expected to do so again in the future, and that we should include that behavior in our definition of the "mutiplier." And if this was the totality of what he was saying, then I was indeed mistaken in bringing out Bat Boy.

But what kind of research would have allowed me to know that Sumner was not going on to assert Possible Claim 3b? I know Sumner has made Claim 2 in the past, but does that mean that that was all he was saying this time? When I read the phrase "the fiscal multiplier IS zero because the Fed STEERS the nominal economy," it sounds to me like a claim that the fiscal multiplier theoretically MUST be zero. Which would just not be true, since the Fed's reaction function might not be policy invariant.

So perhaps I was too quick to say that Sumner's claim was batty. It was simply the case that the claim I thought Sumner was making would, in fact, be batty (i.e. not logical). Perhaps I should have first asked Sumner "What exactly did that statement mean?" before assuming it meant what it sounded to me like it meant. Perhaps I was too quick to jump to conclusions, and ended up knocking down a straw man. And if so, I hereby revoke the Bat Boy from Scott Sumner and award it instead to anyone out there who does believe that the potential effectiveness of monetary policy means that fiscal policy is ineffective by definition...

The Great Ricardian Equivalence Throwdown!

2011-12-29T03:33:00.032-05:00

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

2011-12-26T16:44:00.000-05:00

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

2011-12-25T18:00:00.002-05:00

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)

2011-12-23T19:09:00.005-05:00

"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.

2011-12-21T15:11:00.002-05:00

"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

2011-12-21T14:33:00.004-05:00

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

2011-12-09T17:42:00.001-05:00

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

2011-12-06T18:14:00.008-05:00

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

2011-12-05T22:52:00.006-05:00

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

2011-12-03T15:27:00.004-05:00

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"...

We need a Peter Thiel conservatism

2011-11-28T15:47:00.005-05:00

Peter Thiel has some weird ideas. He thinks there was a "collapse of art and literature after 1945." He wants to live on a floating libertarian utopia made from trash, like the guy in Snow Crash. He'll pay you $100,000 to quit college. But he also has some very good ideas about where to take the conservative movement.

As I see it, modern American conservatism is suffering from a severe deficit of ideas. Back in 1980, the year of the Reagan revolution, the movement was brimming with initiatives. Cut income taxes. Deregulate industries. Get tough on inflation. Get tough on crime. Spend a bunch on the military to scare the Soviet Union. Bust unions. Get tough on drugs. Teach kids not to have sex before marriage. Put Christianity back in public schools.

Fast forward three decades, and that brand of conservatism has lost its raison d'etre. Some of its ideas succeeded, some failed, most had mixed results, but almost none of them has anywhere left to go. Tax rates are already unsustainably low. Stagflation has given way to a liquidity trap. 2.3 million of our people are behind bars. Private-sector unions are a memory, as is the USSR.

So when you ask conservatives for ideas these days, they can make only three suggestions. Cut income taxes EVEN MOAR. "Drill here drill now" (i.e. shut our eyes really tight and wish we were Saudi Arabia). And the third idea... ... ...the EPA? No, that isn't it...oops.

Which is where Peter Thiel comes in. In a brilliant (and only occasionally kooky) article in the National Review, Thiel claims that we are experiencing a long-term slowdown in technological progress (Tyler Cowen's "Great Stagnation"). Without a steady upward march of new inventions and higher productivity, he believes, the world will revert to a zero-sum game:

The technology slowdown threatens not just our financial markets, but the entire modern political order, which is predicated on easy and relentless growth. The give-and-take of Western democracies depends on the idea that we can craft political solutions that enable most people to win most of the time. But in a world without growth, we can expect a loser for every winner. Many will suspect that the winners are involved in some sort of racket, so we can expect an increasingly nasty edge to our politics. We may be witnessing the beginnings of such a zero-sum system in politics in the U.S. and Western Europe[.]

This rings true to me. The middle-class society that liberals have struggled to create seems liable to degenerate into class warfare when the pie stops growing (note that in the U.S. it has been the rich who have initiated and won this class warfare in recent times).

Thiel also recognizes that tax cuts, the conservative movement's magic cure-all-that-ails-ya, are an unsustainable short-term palliative rather than a long-term efficiency booster:

A mischievous person might even ask whether “supply-side economics” really was just a sort of code word for “Keynesianism.” For now it suffices to acknowledge that lower marginal tax rates might not happen and would not substitute for the much-needed construction of hundreds of new nuclear reactors.

Hmm, you don't say!

And then, at the end of his rant, Thiel slips in the paragraph that has the potential to change American conservatism:

Let us end with the related question of what can now be done. Most narrowly, can our government restart the stalled innovation engine?

The state can successfully push science; there is no sense denying it. The Manhattan Project and the Apollo program remind us of this possibility. Free markets may not fund as much basic research as needed. On the day after Hiroshima, the New York Times could with some reason pontificate about the superiority of centralized planning in matters scientific: “End result: An invention [the nuclear bomb] was given to the world in three years which it would have taken perhaps half a century to develop if we had to rely on prima donna research scientists who work alone.”...

Today a letter from Einstein would get lost in the White House mail room, and the Manhattan Project would not even get started; it certainly could never be completed in three years. (emphasis mine)

HALLELUJAH. Public goods FTW!!!

Peter Thiel recognizes and admits what doctrinaire conservatives have been loath to admit: government is not always and everywhere the problem. Sometimes, when externalities and public goods exist, government is the solution.

Conservatives, wedded to the drown-government-in-a-bathtub approach that worked so well for them in the 80s, have since been forced into taking the untenable, indefensible, goonball-"libertarian" position that public goods don't actually exist - that the unfettered market will provide plenty of basic research, infrastructure, etc. But regulation has been slashed, non-entitlement spending has been slashed, tax rates have been slashed, and essential government functions have been privatized...and, if Thiel and Cowen are right, innovation and progress have still slowed down. The Grover Norquist dog is no longer hunting.

What America needs is a conservative movement that does not simply replay yesterday's greatest hits. In the upcoming decades, one of our most pressing priorities (as Thiel recognizes in that article and elsewhere) is going to be finding an energy source to replace cheap oil and coal. This monumental task may not be (probably will not be) accomplished efficiently without massive government spending on basic research and new infrastructure. If conservatives, terrified of deviating even slightly from the Grover Norquist canon, stand in the way of this research, then either liberals will own the future, China will save us, or - more likely - our country will simply settle into a long, grumpy decline.

Moving from a Norquist conservatism to a Thiel conservatism does not mean that conservatives must abandon all their principles. They can call for shifting spending from health care to research and infrastructure, instead of raising the money via taxes. They can call for greater deregulation of biomedical research (another critical area of research). And in no way does acknowledging the important role of government in the economy force conservatives to abandon their cultural principles - hard work, sexual abstinence, Christianity, pre-1945 art, or whatever. In fact, if conservatives feel the need, as Thiel does, to couch their substantive shift in a flurry of hippie-bashing and sneering at "political correctness," well, be my guest, guys! We hippies are big boys and girls, we can take it.

But the idea that "government is the problem" is well past its sell-by date. Peter Thiel recognizes this. Let's hope the rest of the conservative movement catches on.

Update: In general, though, Peter Thiel is a nut.

Federal income tax is the enemy of urbanism

2011-11-25T17:29:00.000-05:00

Finishing my dissertation this year has forced me to come out of my troll-cave and interact a lot more with my econ department. And that has been a very good thing! There is so much cool economics going on at the University of Michigan that I didn't even know about that I've decided to start blogging about it.

Today's interesting nugget comes from UMich prof David Albouy, for whom I briefly worked as a research assistant a few years back. A lot of David's work is in urban economics, which - although I decided not to do my dissertation on it - is an area dear to my heart. I view the deterioration of America's big cities over the past 40 years as a national tragedy, especially after seeing how well big cities work in countries like Japan and Korea. Fortunately, urban economists like Albouy and Ed Glaeser have been leading an intellectual charge for more urban-friendly policies.

David has zeroed in on one way in which our government stacks the deck against cities: Income tax. Here's the original paper, and here's a recent writeup in the New York Times. The basic idea is this: Income tax rates are based only on your dollar income, not on how much purchasing power your income represents. Since prices (especially housing prices) are higher in big cities, an income of, say, $60,000 will buy you a lot less in San Francisco than it will in College Station, Texas. But someone who earns $60,000 will pay the same taxes in SF as she would in College Station. This provides a big incentive to move from the big city to a small town.

The point is not just that this is unfair (as the Times article contends), but that it's inefficient for our economy. Why? Because people are productive when they live in big cities. Take a worker out of San Francisco and plunk her down in College Station, and chances are that she will add less value to the economy.

There are several reasons that this is true. The first is transport costs; if our hypothetical worker makes Christmas tree ornaments for a living, then if she lives in San Francisco, she's going to be very near to a whole lot of paying customers. But if she lives in College Station, she's going to have to ship a lot of her Christmas ornaments to customers in Houston (two hours away) or Dallas (three hours away). That costs money, and reduces the worker's productivity. Transport costs are probably the reason we have cities in the first place.

Another reason is knowledge spillovers. A lot of cities are "industrial clusters". If our Christmas tree ornament maker lives in SF, she will be smack dab in the middle of the center of the U.S. technology industry. This means that she may hang out with engineers who will teach her how to design ornaments more efficiently using powerful software, or how to find customers and suppliers more effectively using the Web. And she may also interact with a bunch of art and design people, for whom SF is also somewhat of a mecca. That will also tend to increase her productivity, by keeping her on top of new trends and ideas in the design world.

So when the federal government levees the same percentage tax on San Franciscans that it levees on people in College Station, it is discouraging high productivity. Just how much this hurts our economy is anybody's guess, though David Albouy takes a crack at an estimate in his paper; the numbers come out substantial, though not huge. But the policy implication is clear: one way to help reverse America's urban decay, and to boost our economy over the long term, would be to tax people in big cities at lower rates.

Who Wins? A Taxonomy.

2011-11-18T14:44:00.003-05:00

As a follow-up to my last post, here's my attempt at a taxonomy of "who wins" under various economic systems. You may perhaps detect a smidgen of a hint of bias, but pay no heed. ;-)

Hunter-Gatherer Society: No one wins.

Classical Slaveholding Society: Those who choose the right parents win, everyone else loses.

Feudalism: "Winning" means knowing your place, serf! Now be so good as to polish my boots.

Theocracy: "Winning" comes only in the next life. Now send us your money and you will be on God's good side.

Marxism (theoretical): Everyone wins equally! (details to follow...)

Marxism (applied): Everyone loses equally...but if we had just implemented it correctly, everyone would have won equally! (details to follow...)

Laissez-Faire Capitalism: Anyone can win big, if he works 0.001% harder than the people standing next to him!

Ayn Randism: The Ubermenschen would win if those darn Untermenschen just stopped their looting and mooching!

Nazism: The Ubermenschen will win, the Untermenschen will make lovely decorative candles.

Japanism: Everyone wins (as long as he is born with a Y chromosome, does well on his entrance exams, and swears lifetime fealty to a large famous corporation with good connections in the bureaucracy, mafia, and ruling political party)!

Europeanism: We just need to define a better measure of "winning." Such as how many teenage girls are currently partying at my villa. Bunga bunga!

Tea Party Conservatism: Every Real American would win, if those lazy blacks and Mexicans stopped stealing our hard-earned money with All Those Government Programs. Now keep your hands off my Medicare!

Mushy Milquetoast Middle-of-the-Road Mixed-Economy American Liberalism: Everyone can win a reasonable amount, as long as they work hard and play by the rules. And if someone gets lucky or has a great idea they can win even more.

And the winner is...Ayn Randism!

Easy choice, right? :-)

Why conservatives can't get people to work hard

2011-11-16T22:41:00.002-05:00

"A city is made of brick, Pharoah. The strong make many. The weak make few. The dead make none." - Moses

I'm a bit late to the party here, but I thought I'd offer some comments on Tyler Cowen's recent New York Times column about discipline and hard work. First, some excerpts:

[A]s someone from a conservative and libertarian background, I find that I am hearing too much talk about riches and not enough about values...

Conservatives often believe that much of the poverty in the United States is an issue of insufficient discipline and conscientiousness...Yet how can such a culture of discipline be spread? [I]t has been argued that society should grant respect to business creators and to stern parents who instill discipline...

But are such moves, when carried out, actually shifting popular culture in a properly disciplined and conscientious direction? Not really. In fact, in the United States, the red states, where conservatives are more powerful, tend to have higher divorce rates and weaker educational systems than do blue states...

The counterintuitive tragedy is this: modern conservative thought is relying increasingly on social engineering through economic policy, by hoping that a weaker social welfare state will somehow promote individual responsibility. Maybe it won’t. (emphasis mine)

I think this is extremely insightful, and I am delighted to hear people beginning to say this.

See, this is one of the big problems I have with conservatism as an ideology: Conservatives really want people to value hard work and discipline (not to mention sexual abstinence), but they typically have no idea whatsoever how to get people to actually value these things! Like the military dad in American Beauty, they think that they can just beat their values into the populace...except instead of fists and feet, the cudgel they try to use is poverty. Without a welfare state, the thinking goes, people who slack off and party and have sex will be forced to live with the consequences of their actions; having been stung by the lash of economic hardship, they will see the light, toughen up, and go get a real job.

Sounds like tough love. No wonder people call the Republicans the "daddy party"! But unfortunately, this just doesn't work on most people. There are at least four big reasons I can think of, off the top of my head.

For one thing, people who want to party and slack off have too many outside options. They can turn to the black market (selling drugs, etc.). They can sponge off their families. They can sponge off their spouses. They can go to grad school.

For another thing, being poor in America, or any rich country, is just not that bad. Even if you work at McDonald's, you can probably afford plenty of junk food, a heated room, a comfy old couch, a CRT TV, some old video games, a cheap used car, beer, and marijuana, and you can probably find people to have sex with you. Not exactly the Ritz, but not exactly the pangs of privation either!

An even bigger reason that the "tough love" approach to social engineering doesn't work has to do with the nature of human motivation. In my life, I have experienced both positive motivation (e.g. the chance to have a future I want) and negative motivation (the fear of failure). The latter works much better in short-term crunch-time situations - for example, "I had better study really hard right now or I'm going to fail this econometrics test, and my professor will kill me on the spot."

But that kind of fear doesn't work very well over longer periods of time - for example, in getting me to finish my dissertation. Eventually, fear and panic just grind you down and impede your productivity. Far more effective over the long run is positive motivation. Thinking about things I want gives me a positive boost and improves my overall energy level, in addition to the incentive it provides. So if conservatives want to get people to work hard, beating them repeatedly with the lash of poverty is not the best way to go about it. You'll end up with a bunch of poor people who are too exhausted, harried, and depressed to pick themselves up by their bootstraps. Henry Ford is one person who understood this.

Finally, there is one more reason why the "tough love" approach doesn't end poverty. That reason is social preferences. When you structure society so that there are a lot of poor people, then the lifestyle of poverty becomes "the thing to do." There are just so many poor people around that poor kids don't come into contact with anyone else. Poverty then becomes their world, and their aspirations and desires do not escape the ghetto. They grow up thinking that gangsters, not successful businesspeople or professionals, are the Big Dogs of society. They have no idea that hard word brings middle-class prosperity, because they don't see any examples of that happening...but, even worse, they don't really want to become middle class. They want to succeed within the context of the subculture within which they are embedded (note to sociologists: I am just making up terms left and right here). To a poor kid, a rich kid's version of "success" might look kinda neat, but it's too weird and alien and remote to be worth the effort.

So there are tons of reasons why simply smashing the welfare state doesn't instill poor people (or anyone at all) with good values. The beatings may continue, but morale will not improve. To conservatives, I say: If you really want people to value hard work and discipline, you've got to come up with a real, workable plan for achieving that goal.

What would such a plan look like? Loath as conservatives are to admit it, many liberals not only value hard work intrinsically, but have thought long and hard about what kind of social engineering would actually spread those values.

One basic idea is that hard work should be rewarded. Obvious, right? I mean, we're supposed to be economists here! People respond to incentives, and they are risk averse. A winner-take-all society is not very conducive to hard work; I'm not going to bust my butt for 30 years for a 1% shot at getting into The 1%. But I am going to bust my butt for 30 years if I think this gives me a 90% chance of having a decent house, a family, some security, a reasonably pleasant job, a dog, and a couple of cars in my garage. An ideal middle-class society is one in which everyone, not just anyone, can get ahead via hard work.

Liberals have tried hard to construct such a middle-class society. They came up with worker health and safety regulations, weekends, Social Security, labor unions, public schools, living wages, government-subsidized housing loans, grants and loans for college, earned-income tax credits, job retraining, and tax breaks for health care. Some of those ideas worked spectacularly, some failed. Many had mixed results. But the basic idea was sound: not just to give people handouts, but to make them feel as if they deserved what they were getting because of hard work.

Conservatives, meanwhile, are all too often divided on whether they actually believe that hard work works. Plenty of conservatives have undermined Cowen's hard-work-and-discipline bloc by saying that success in life is all due to natural differences in ability. These "I.Q. conservatives" see inequality as the natural order of things. They have focused on getting people to accept their place in society and learn to live with what they have, rather than strive to move up in the world. This is a very Old British sort of conservatism, a nobility-and-peasants ethos dressed up in the faux modernism of psychometric testing.

Conservatives need to look in the mirror and ask themselves: "Do we really want people to work hard and be disciplined? Or do we just say that in order to keep the peasants from getting restless, when deep down we believe that it's all about good genes?" Because if it's the former, conservatives should do some hard thinking about what actually gets people to work hard. And they should think about how to respond to those among their colleagues for whom it is simply the latter.

Is America's financialization China's fault?

2011-11-16T21:05:00.003-05:00

This morning, as I read the latest big expose on the continuing financialization of America's economy (this one courtesy of the excellent Amanda Terkel), I once again felt the insistent tug of a question that has been worrying at my brain for quite some time now: What is the root cause of financialization?

Financialization is real, and has been huge. For a thorough discussion of the phenomenon and an overview of related research, see Wouter den Haan. But the basic story can be grokked in two graphs. First, here's the finance and insurance industries as a percentage of all value added in the U.S.:

Now here are finance-industry profits as a percent of all corporate profits:

When we see a shift this big, there are two natural explanations. The first is that financialization is a natural and inevitable part of economic development. The second is that something big in the global economy is causing the shift.

Intuition says it's a combination of the two. Most advanced nations see a shift toward "services" as their economies mature; this is even true of Germany and Japan, where manufacturing is almost a religion. And there is an intuitive explanation for this: as catch-up growth and "extensive" growth peter out, owners of capital place a higher premium on ferreting out new investment opportunities - companies with new technologies, companies with new trade opportunities, and investment opportunities in developing countries. The industry that sniffs out those opportunities for uninformed rich people is the finance industry.

But there is also reason to believe there are "shocks" at work. Go back before 1945, and you'll see finance making up a relatively high percentage of America's economy during the first two decades of the 20th century. This suggests that there are contingent factors at work...and the obvious culprit is globalization, which ballooned in the early 20th century, collapsed during WW2, and then began a long steady rise after the bombs stopped falling.

How could globalization enable America's finance industry to take over America's economy? We have all heard of the "demand-side" factor here - the idea that America, with its "deep" and "liquid" financial markets, simply has a comparative advantage in managing money relative to other countries, and hence other countries beat a path to our door to get our banks and hedge funds to manage their money for them. In this story, globalization mainly acts as an enabler; reducing barriers to international capital flows simply allows the world to access our financial markets.

This was the dominant story leading up to 2008, and I instinctively distrust any story that was dominant leading up to 2008. Since then, there have been rumblings of another story of why globalization might have caused financialization - a story about the supply of capital rather than the demand for returns. This is an extension of the "savings glut" story that Ben Bernanke was telling during the 2000s as an explanation for our trade deficit: China and other exporters wanted to pump up exports, so they kept their currencies cheap. This required buying a lot of dollar-denominated assets (in practice, this meant Treasuries), which flooded America with cheap capital. This simultaneously made American manufacturing less competitive, and created profit opportunities for American financial firms via low interest rates that let them lever up.

Brad DeLong told a variant of this story in a blog post a couple weeks back:

The 4% of GDP trade deficit that we have on average run over the past decade is best viewed as yet another shift of the US economy into the insurance industry: in this case, a shift inro the "industry" of providing political risk insurance...the only reliable way we know for a poor country to become richer is...by exporting low and relatively simple manufactured goods to the rich...That requires a low value look for the...currency. And that requires that the government manipulate the currency by buying large amounts of dollars...Developing country governments, especially in Asia, think that this political risk insurance policy is well worth buying...The question, however, is whether this American specialization in finance and in the sale of political risk insurance is truly intelligent. Are these the "industries" of the future? Or is this rather a path that leads to a dimmer future for middle-class America?

DeLong explicitly links the trade deficit to financialization. This argument has a lot of intuitive appeal to me - partly, I admit, because of my general dislike of China's currency policy. If China's mercantilism is causing our financialization, that's one more reason to fight back. It would be cool if I could write "The Occupy Wall Streeters should be demanding that we pass the yuan bill!"

But to be intellectually honest, I have to admit there are some obvious problems with the hypothesis. One is that, although the profit-based measure (second graph above) shows financialization exploding after 2000, the value-added measure (first graph), rose steadily since WW2 and then actually leveled off after 2000. So the correlation of Chinese surpluses with American financialization depends on what measure you use for the latter. A second problem with the theory is that there was also some degree financialization in the 1920s, when America was running big current-account surpluses (much like China is today).

So I'm left without a clear conclusion. Are there good studies out there that look at the correlation between a nation's capital flows and the size of its financial sector? I can't find any, but perhaps they exist. If you know of one, please let me know.

A proposal for Greg Mankiw's Economics 10 course

2011-11-13T18:01:00.002-05:00

First, let me say that I think it's a tad silly to walk out of a survey course because you think it's biased and incomplete, before you actually complete the survey course. How are you supposed to know what's left out before you know what's been put in? And how are you going to recognize bias without being well enough grounded in the field's methodologies that you can critically evaluate the ideas that the class left out? The fact is, Greg Mankiw's Principles of Economics is far to the "left" of the econ profession itself; it teaches Keynes but not RBC, and gives "supply-side economics" the half-page dismissal it deserves. If the kids who walked out of Greg Mankiw's introductory economics course had stayed til the end, they might have realized this.

That said, I do sort of sympathize with one point made by the kids. In their open letter, they say:

A legitimate academic study of economics must include a critical discussion of both the benefits and flaws of different economic simplifying models. As your class does not include primary sources and rarely features articles from academic journals, we have very little access to alternative approaches to economics.

This rings true to me. Economics is not physics or biology; there are very few modeling approaches that we really know work. Most of the time, we are still groping around in the dark, relying on our intuition, and taking clumsy stabs at first-pass models. For an upper-level textbook, this is just unwritten and understood; grad students, or even upper-level undergrads, understand that while what they're reading may be written in highly formal math-ese, it usually represents merely the stylized description of an idea that may at some point in the future prove useful for understanding the economy.

An intro textbook is different. Part of the job of an intro or survey textbook is to convey the state of the field to people who will probably not spend their lives as researchers in that field. Intro physics textbooks present Newton's laws in part because those laws work really really well, and thus provide a convincing demonstration of what physics can do. But an introductory economics textbook presents things like the the AD-AS model, the Solow growth model, or the Keynesian cross - models that seem reasonable to our intuition, and for which there is some supporting evidence, but which come with much wider bands of "model uncertainty" due to our inability to test the macroeconomy in a lab. These are the best we've got, but they're no Newton's laws.

So I think an introductory econ textbook should work to convey that uncertainty. I've read every word of (an older edition of) Mankiw's Principles of Economics, and I've taught from the book as well. And while it does a great job of presenting the standard macro (and micro) models in simple and usable forms, it doesn't say as much as I'd like about the massive degree of doubt and ignorance that surround even these bedrock models (actually, I'm not sure what intro textbook does).

Greg Mankiw himself is certainly aware of the uncertain state of macro. In an article earlier this year, he wrote:

After more than a quarter-century as a professional economist, I have a confession to make: There is a lot I don’t know about the economy. Indeed, the area of economics where I have devoted most of my energy and attention — the ups and downs of the business cycle — is where I find myself most often confronting important questions without obvious answers.

I think this idea should be front and center in any introductory economics textbook. If we don't stand up and admit how little we know, plenty of tomorrow's businessmen and lawyers and professionals are going to graduate thinking that the macroeconomists have got it covered. And that could translate into false certainty in political debates, or even in business decision-making.

So anyway, here is my suggestion for Greg Mankiw's Economics 10 course: He should assign students each to report on one theory or technique that they believe is not covered in sufficient depth in the textbook, and to give a presentation on this topic. That would A) convey something about the diversity of ideas out there, as students have demanded, B) give students practice in seeking out and evaluating ideas, and C) make apparent the limitations of class walk-outs as a tool for widening the discussion.

(If I got that assignment, BTW, I'd talk about theories of financial bubbles and mispricings, like the DeLong et. al. and Abreu & Brunnermeier noise trader models, the Harrison & Kreps and Morris heterogeneous-beliefs models, and the O'Dean and Scheinkman & Xiong overconfidence models...)

No, a science major does not guarantee you a job...

2011-11-10T14:00:00.008-05:00

Phil Plait of Bad Astronomy is someone I respect a great deal, and I love his blog. But in this post, he tells one of the most blatant whoppers I've seen on the web in recent memory. The title of the post is "Want a job? Study science." The idea is that if you had just gone into a scientific career, you wouldn't be unemployed:

I heard of a database of college majors compiled by the Wall Street Journal based on the 2010 Census. Looking at people who took those majors in college, it lists...the employment rate for that major.

I took a look, and listed the jobs by the lowest unemployment rate, asking, essentially, "Which jobs had the best chance of getting you a job after college?"...I highlighted one in particular: Astronomy and Astrophysics. Note that it has a 0% unemployment rate; in other words, last year everyone who majored in these fields got a job!...But look at the list more carefully...four of these ten majors are science-based (pharmacology, astronomy, atmospheric sciences, and geological engineering — yes, that last is not technically a science, but is science-based). If we broaden our look to science and technology, the list grows longer (especially if you go beyond the top ten)...

[L]earning science trains you in a way that makes you employable. I have friends who left astronomy after grad school and got jobs doing climate modeling, computer game server programming, economic forecasting, and more. Once you learn the methods of science, you’re better prepared for working in other fields as well...

But here’s the irony: a lot of folks in the government claim they are all about making sure Americans have job opportunities...If you want Americans to have good prospects out of college, find good jobs, and contribute to society, it seems to me that teaching science and technology are the very things you should be supporting most.

First, let me say: I absolutely support teaching science and technology, a lot better and a lot more than we are doing right now. This is absolutely 100% right.

BUT, the story Phil is telling is just not right. Not right at all. It implies the same thing that many conservatives are saying openly - that the root of unemployment is on the supply side. That our high unemployment rate is simply due to the fact that we're not teaching kids the right stuff, or maybe that kids are choosing wimpy majors. And that story is just wrong wrong-ity wrong. This has been remarked upon by Matt Yglesias and Ryan Avent already, but just to drive the point home, I went through the Wall Street Journal database that Phil cites, and found the following unemployment rates:

Genetics: 7.4% unemployed
Biochemical Sciences: 7.1% unemployed
Neuroscience: 7.2% unemployed
Materials Engineering and Materials Science: 7.5% unemployed
Computer Engineering: 7.0% unemployed
Biomedical Engineering: 5.9% unemployed
General Engineering: 5.9% unemployed
Engineering Mechanics Physics and Science: 6.5% unemployed
Chemistry: 5.1% unemployed
Electrical Engineering: 5.0% unemployed
Molecular Biology: 5.3% unemployed
Mechanical Engineering and Related Technologies: 6.6% unemployed

Compare these with a 5.0% unemployment rate for all bachelor's degree holders in 2010.

Earth to Bad Astronomy: your short-list of fully-employed science majors is totally cherry-picked. (Note: the previous sentence is overly cheeky. I didn't think it was intentionally unrepresentative.) Overall, science and engineering majors are suffering right along with everyone else in the country, because that is what happens when we are in an economic depression. And all those astronomers who have plenty of jobs? Guess what: they're employed because they work for the government. Yep, that's right, the same government whose ability to provide employment Phil laughs at. (Note: I was counting universities as part of the government, which is of course not precisely true. So, government or nonprofit. But the point stands: education, along with health, is the best field to go into right now if you want to be guaranteed a job.)

In other words, Macroeconomics: 1, Get-a-Haircut-and-Get-a-Real-Job-ism: 0.

If you want a job, consider not voting for politicians who think fiscal austerity is a smart move. And in the longer term, if you want a job, consider voting for politicians who will regulate the finance industry.

Update: Phil Plait responds. Yes, I definitely did get colorful with the phrase "cherry-picking"...I'm sure Phil didn't intentionally ignore all the science majors with high unemployment. And yes, universities are not entirely government-funded. He and I both agree, of course, that better science (and math) education would be a really good thing, and that conservative ideologues who want to take science out of school curricula are threatening the future of the nation.

Also, I'd like to point out that Phil's immediate acknowledgment of his oversight stands in stark contrast to how most bloggers, especially econ bloggers, usually respond when they make errors. I feel like there really is something special about the culture of scientists. I think economics could use a lot of that skeptcism and intellectual honesty.

Let them eat NGDP

2011-11-08T18:18:00.006-05:00

This weekend, at an INET conference, Mike Konczal of Rortybomb made the excellent point that the econ blogosphere is probably adding more new policy ideas to the public discourse right now than academia itself. He identified NGDP targeting as the most important and dramatic example.

And boy was he right! NGDP frenzy has reached truly astonishing levels. I have my doubts that the Fed will actually adopt an NGDP target, but there is no denying that the blogosphere and much of the popular press has fallen for this idea like girls at my college fell for Thom Yorke back in 1999 (no I'm not bitter, why do you ask?). These days Scott Sumner says "NGDP" like Herman Cain says "9-9-9." Now, I am all for looser monetary policy, whether it comes in the form of an NGDP target or not. But NGDP has reached the point where, like Radiohead, its cult status is actually starting to annoy me.

Take, for example, this post from Matt Yglesias (an extremely sharp dude) on how NGDP is the "actual thing":

[I]t seems natural to many people to take [real GDP and inflation] as “given” and understanding NGDP (= GDP + inflation) as somehow constructed and exotic. But actually NGDP is, relatively speaking, the simple quantity here. It measures total spending in the economy. You count everything, add it all up, and you’ve got your NGDP...Social construction enters the picture when we try to move from this nominal quantity to the allegedly “real” one...

[W]e have all these different measures of inflation...[but it's]not directly measurable the way NGDP [is]...Nor is it particularly clear what, in principle, “real” GDP is measuring. Think up all the classic critiques of GDP as a measure of human welfare...When you shift from GDP to “real” GDP, though, you’re not measuring the total quantity of spending anymore.

I just don't think this is the right way of seeing it.

Matt's main point is that because inflation is mismeasured, real GDP ("RGDP") is also mismeasured. Sure, that's true (though of course NGDP itself is not measured with anything remotely approaching certainty). But that doesn't mean NGDP is "better" than RGDP. An accurately measured number is not necessarily more useful than a less accurately measured number, if the latter is something we care about and the former is something we really don't.

In terms of economic well-being, we do not care about NGDP. Or at least, we shouldn't. To see this, take the example of Zimbabwe. In 2007, Zimbabwe's NGDP grew at a rate of over 60,000%! No, that is not a typo. The "total quantity of spending" in Zimbabwe at the end of 2007 was more than 60,000 times what it was at the beginning of 2007. For real.

Anyone still think NGDP is the "actual thing"?

The problem with NGDP is that you can't eat it. It really is just numbers on a page. Normally, it is a reasonable approximation to a measurement of stuff we can eat. But when someone starts playing around with the numbers on the page, as in Zimbabwe's hyperinflation in 2007, NGDP stops being any kind of measure of stuff we can eat.

In other words, NGDP has a potentially large source of mismeasurement in it, and that mismeasurement is inflation itself. When we try to take NGDP and recover some kind of measurement of how much eat-able stuff our economy produces (i.e., RGDP), we have to try to account for the mismeasurement represented by inflation. And of course we end up mismeasuring inflation, as Matt points out, but all that means is that we are mismeasuring our mismeasurement of RGDP. Inflation is still the first-order mismeasurement.

Actually, the world abounds with cases like this. It's easy to measure how many hours a worker sits in front of a desk, but hard to measure how much useful work (s)he actually accomplishes in that time. But it's the latter we care about, not the former.

Now, I am not saying that the U.S. is in danger of hyperinflation. It's not. Nor am I saying that RGDP is a perfect or even a great measure of human happiness. It's not. My point is that NGDP is not supposed to be a measure of how well the economy is doing. People who support NGDP targeting, like Scott Sumner, support it because they believe that NGDP is a good indicator of how much money we should print. Not because they think that NGDP is intrinsically good.

NGDP may be less indirectly measured, but RGDP is still the "actual thing."

Like I said, I support printing money and buying stuff. And I think OK Computer was a rockin' album (and Kid A and The Bends were good too). But thinking of everything in terms of NGDP does not make all of macroeconomics suddenly simple and comprehensible and predictable. And Radiohead didn't save rock. Sorry, fans, but there it is.

Update: Scott Sumner agrees about Radiohead. Unfortunately, he says I'm "criticizing NGDP" and "missing several key points." Huh?? If you read the above post, you'll notice me saying:

My point is that NGDP is not supposed to be a measure of how well the economy is doing. People who support NGDP targeting, like Scott Sumner, support it because they believe that NGDP is a good indicator of how much money we should print.

In Sumner's "rebuttal," he writes:

NGDP is...the proper indicator of nominal shocks...[it's]a nominal shock indicator, not an indicator of living standards. I’d be the first to admit that RGDP, with all its faults, is a better measure of living standards than NGDP...[but NGDP is more] useful in developing optimal monetary policy.

Not to be excessively whiny, but is that not exactly what I just said???

So exactly what "key points" am I missing? And how on Earth am I "criticizing NGDP"? My gosh, people. NGDP is an economic indicator, not a fair damsel in need of gallant knights to defend her maiden virtue. Settle down!

"NGDP targeting" means "print money and buy stuff"

2011-11-02T18:31:00.003-04:00

The econ blogosphere is afire with talk of "NGDP targeting." I don't have a huge amount to add to this discussion, but this post by Greg Ip caught my eye:

[There is] flawed reasoning behind the newborn infatuation with nominal GDP targeting. Its advocates, which include my colleague, R.A. and Goldman Sachs, now include Christina Romer...

A nominal target can affect expectations in two ways. First, it influences markets’ expectations of what the Fed will do, thereby amplifying monetary actions...But there are many, potentially superior, ways to achieve the same thing, such as a promise to keep short-term interest rates at zero for a specified period of time, to target bond yields, or to keep rates low until a particular inflation or unemployment rate is achieved...Second, a nominal target should encourage firms and workers to behave in a way that makes the target self-fulfilling.

NGDP advocates base their arguments on a flawed premise: that with a different framework the Fed would have been less concerned about inflation and more about output, and would have thus eased more aggressively.

Basically (and yes, this is a simplifaction), what the Fed can do to affect the macroeconomy is 1) print money and buy stuff, and 2) convince people that it will print money and buy stuff in the future.

Many people want the Fed to print money and buy stuff because they believe that printing money will increase economic growth and therefore reduce unemployment. Others don't want the Fed to print money and buy stuff, because they fear that this will lead to inflation. Political pressure from these two groups, but especially from the latter, tie the central bank's hands in practice, even though in theory the central bank is supposed to be independent and do whatever it thinks is best.

However, some people believe that the Fed doesn't always have to actually print money and buy stuff in order to boost economic growth. If the Fed manages to convince people that it will print money and buy stuff in the future, these people say, businesses and consumers will anticipate this and economic growth will rise in advance. Then the Fed won't actually have to print money and buy stuff, so the danger of inflation will be averted.

"NGDP targeting" is a way to convince people that the Fed is willing to print money and buy stuff. Specifically, it is a way to convince people that the Fed is willing to print as much money and buy as much stuff as is necessary for economic growth to rise. If the Fed says "we are now adopting an NGDP target," some economists think, people will believe that the Fed is willing to print quite a lot of money and buy quite a lot of stuff, and their reluctance to buy things will crumble.

There are reasons to be skeptical of this. The main reason is that people will probably not take the Fed seriously at first. After all, the Fed has proven pretty unwilling to print money and buy stuff lately, even in the midst of a long grinding depression. Why should people believe that the Fed's behavior has fundamentally and hugely changed?

They shouldn't, so what the Fed will have to do in order to make NGDP targeting work is to prove that it is not bluffing. The only way to do that is to actually print a bunch of money and buy a bunch of stuff. In other words, throw a few people against the wall to show it means business.

But everyone knows the Fed will probably not do this, because of political pressure from conservatives. As soon as the Fed started actually printing money and buying stuff, conservatives would howl, and the Fed would cut it out. And at that moment, everyone would know that the NGDP target was a lie, and it would be dropped.

How do we know that political pressure from conservatives is so strong? Well, ironically, one way that we know this is from the popularity of NGDP targeting itself! As Greg Ip writes:

There is, of course, one rather unseemly advantage to NGDP targeting, that Paul Krugman alludes to here: it is a surreptitious way of temporarily raising the inflation target without the toxic politics of doing so explicitly...One should normally be wary of a monetary policy that achieves its objectives through subterfuge, but desperate times call for desperate measures.

In other words, NGDP targeting is popular in large part because the words "NGDP targeting" are less offensive to the hard-money types, inflation hawks, Republican politicians, John Taylor's army of clone cyborg stegosauruses, etc. This is probably because A) "NGDP" sounds less scary than "inflation" or "printing money" to non-intellectual conservatives and B) the advocates of NGDP targeting focuses on the fact that it acts through rational expectations, which intellectual conservatives are supposed to like.

That in itself tells you exactly how likely it is that an NGDP target would hold up if anyone called its bluff...i.e., very unlikely. Hence, it is very likely that the bluff would be called. Hence, knowing that the bluff would be called, the Fed will not adopt an NGDP target. Game theory in action.

I do think that "print money and buy stuff" is a good thing to try to get out of a recession. However, it strikes me as a bit farcical to think that the only way to implement this policy is to simultaneously A) convince businesspeople that the Fed is willing to print massive amounts of money, and B) convince Republicans that the Fed is not going to print massive amounts of money. It's just not going to work. Has our politics really gotten so dysfunctional that this is our best idea? Well, you can answer that one for yourself.

(Note: anyone who does not know the meme referenced in the Bernanke picture is either old, or obviously doesn't spend enough time surfing the web and getting into flame wars on Facebook...)

Niall Ferguson does not know what "Western Civilization" means

2011-10-31T21:32:00.022-04:00

"The blood of Numenor is all but spent, its pride and dignity forgotten." - Elrond

I am forced to break my self-imposed blogging moratorium, in order to comment on an article by Niall Ferguson that recently appeared in what is left of Newsweek magazine. In this article, Ferguson warns darkly of a rapid collapse of American civilization. The article is, on its face, a fairly bland call for America (and "The West" in general) to wake up, get with the program, and recover its lost greatness. Fine. But there is a deeply disturbing subtext that annoyed me so much that...well, here, I'll just let you see for yourself.

First, Ferguson's thesis:

I believe it’s time to ask how close the United States is to the “Oh sh*t!” moment—the moment we suddenly crash downward...

The West first surged ahead of the Rest after about 1500 thanks to a series of institutional innovations that I call the “killer applications”:

1. Competition...

2. The Scientific Revolution...

3. The Rule of Law and Representative Government...

4. Modern Medicine...

5. The Consumer Society...

6. The Work Ethic...

For hundreds of years, these killer apps were essentially monopolized by Europeans and their cousins who settled in North America and Australasia. They are the best explanation for what economic historians call “the great divergence”: the astonishing gap that arose between Western standards of living and those in the rest of the world...

Beginning with Japan, however, one non-Western society after another has worked out that these apps can be downloaded and installed in non-Western operating systems...

Now, before I move on to the really annoying part of Ferguson's article, this talk of "non-Western operating systems" has already rankled. What the heck is the "operating system" of a society? What inherent quality of "Western-ness" does Ferguson imagine Japan fundamentally lacks, such that even though Japan has representative democracy, property rights, competitive capitalism, work ethic, science, and medicine, the Land of the Rising Sun is still running on a "non-Western operating system"?

Is it Christianity? But then South Korea would be "Western," since it is majority Christian (and far more religious than, say, France). And Ferguson cites Korea as a "non-Western" civilization in his very next paragraph (which I'll get to in a moment).

Is it geography? Would Ferguson exclude Australia and New Zealand from "the West"?

I think you see what I'm getting at, and just to drive it home, here's Ferguson's next paragraph:

Ask yourself: who’s got the work ethic now? The average South Korean works about 39 percent more hours per week than the average American. The school year in South Korea is 220 days long, compared with 180 days here. And you don’t have to spend too long at any major U.S. university to know which students really drive themselves: the Asians and Asian-Americans. (emphasis mine)

So a sign that American civilization is in decline is that...Asian-Americans study hard?

Labeling Asian Americans as "non-Western" gives away the game completely. By "Western," Niall Ferguson is not referring to a geographic region, a political system, an economic system, or a religion. He is not even referring to a specific set of countries. He is referring to a set of people; people who have pale pinkish skin, fine wavy hair, and prominent eye ridges. By "Western," Niall Ferguson means "white people." Asian Americans may have American passports, Ferguson thinks, but civilizationally speaking they are permanent foreigners. This interpretation is basically confirmed a couple paragraphs later:

Social scientist Charles Murray calls for a “civic great awakening”—a return to the original values of the American republic. He’s got a point.

When you admit to taking your cues from America's most prominent academic racist, you've pretty much laid your cards on the table.

This makes me sick, and not just because of the racism. It's because Ferguson's offhand exclusion of non-whites from the "Western" world is, in fact, what I believe to be the biggest threat to our civilization.

You see, I believe that the United States of America has another "killer app" in addition to the ones Ferguson lists. That killer app is meritocratic diversity. Where other countries cling to blood-and-soil tribalism, America absorbs and employs the energy and talent of a vast array of peoples. All those American Nobel Prize winners? A huge chunk are immigrants or children thereof. Ditto for Silicon Valley's entrepreneurial heroes. Our above-average fertility rates? Largely thanks to immigration.

Imagine if this were 1911, and Ferguson had instead lamented: "And you don’t have to spend too long at any major U.S. university to know which students really drive themselves: the Jewish-Americans." He might have held this up as a harbinger of Western decline - after all, Jews were not at the time considered white. But he'd have been pooh-poohing the future contributions of Albert Einstein and Richard Feynman, not to mention Larry Page, Sergei Brin, Mark Zuckerberg, and probably a bunch of other Jewish Americans whom I don't know off the top of my head. The contribution of the Asian Americans whom Ferguson now dismisses are growing at a similar, if not faster rate.

In fact, Niall Ferguson pines for the days of Anglo-Saxon empire, but in fact, many historians believe that race-blind meritocracy is the key to all successful hegemons. Empires of the past have been successful when, like modern America, they didn't limit their talent pool to people with the right genes.

The biggest threat facing American civilization now is not loss of work ethic - Americans still work more than the rich-world average. Nor is it insufficient consumerism (believe you me), the abandonment of modern medicine, the end of rule of law, creeping monopolies, or the abandonment of science. It is political dysfunction and distrust of our national institutions, brought on by the refusal of a large bloc of white Americans (the "Tea Party" etc.) to accept nonwhite Americans. The very denial of "Western-ness" to nonwhite Americans is what is threatening the West. Articles like Ferguson's, in other words, are part of the problem, not part of the solution.

Here's my idea for how to revitalize Western civilization. Widen the big tent. Recruit smart people from all over the world to be Americans. Renew the idea of America as a nation defined by principles and institutions rather than by race and tribe. Assimilate Asians and Hispanics the way we assimilated Italians and Greeks and Jews a century ago. Promote nationalism as a unifying force rather than racism, in order to rebuild trust in public institutions and improve the provision of public goods.

And further afield, do not exclude the rising nations of Asia from "the West." To do so would instantly doom us to geopolitical extinction. Just because Japan, India, South Korea, and the rest of our Asian allies lie beyond the International Dateline does not mean that they don't share the principles and institutions and philosophies embraced by Europe and America.

Anyway, there's my main rant. Now for a few more miscellaneous knocks on this truly execrable piece of public discourse:

Ferguson claims that societies decline quickly rather than slowly. That is poppycock. Go read Ian Morris' Why the West Rules - for Now. You will see that the declines of Rome, the second Chinese empire, and other ancient civilizations all took centuries.

Ferguson chides Americans for not working as hard as the industrious South Koreans. However, he neglects to mention that the second, third, fourth, and fifth hardest-working countries are Greece (!), Hungary, the Czech Republic, and Poland. Aren't those countries part of the "West"?

When explaining why "competition" is one of the West's "killer apps," Ferguson recalls that "Europe was politically fragmented into multiple monarchies and republics." Later, as an example of a competitive powerhouse, he cites...China. Yes, China, that fragmented, decentralized ferment of political competition...

Ferguson chides America for not being sufficiently consumerist (no, really!!), and for having empty malls. This is supposedly in contrast to China. Here is a video of one of China's many "ghost malls," which happens to be the largest mall on the planet. Yes, Ferguson really is that sloppy.

Ferguson suggests that we "delete...the politically correct pseudosciences and soft subjects that deflect good students away from hard science." Niall Ferguson is a professional historian. Seriously.

Ferguson suggests eliminating America's "quasi-monopoly" on education - I assume he means public schools - in order to compete with countries like South Korea. South Korea, of course, has the world's best quasi-monopoly...er, public schools.

Basically, this is one of the laziest, sloppiest, most pernicious columns that I have ever read. I am simply physically, biologically incapable of sticking to my self-enforced blogging hiatus when something this awful crosses my screen.

(P.S. - credit for the Elrond quote goes to my friend Ry.)

Another blogging hiatus

2011-10-23T21:58:00.001-04:00

Work calls again. Regular blogging will resume November 3. In the meantime, satisfy your Noahpinion cravings by staring at this cute picture of polar bears.

I mug pandas

2011-10-15T19:23:00.007-04:00

Two things I don't understand. The first is why people think pandas are so unbearably cute. They're not bad, but I think they are out-cuted by most bears out there, including polar bears, brown bears, and maybe even black bears. Who's with me?

The second thing I don't understand is why opponents of attempts to "get tough" on China's currency policy - call them the Panda Knights - are comfortable with simplistic arguments and hand-waving dismissals. I realize that "free trade" is one of the few issues on which economists have allowed them to think they have a consensus over the past half-century. And I also realize that trade wars are scary in a geopolitical sense, regardless of the economics. But that is no reason to ignore the serious scholarly research that supports the idea of getting tough with China, or to assume that Congress' attempts to do so constitute political pandering.

One example of this sort of analysis is Michael Cohen's recent piece in Foreign Policy magazine, entitled "Panda Mugging." Here's the economic argument:

[A stronger yuan] would likely lead jobs to trickle to other low-wage countries rather than back to the United States -- a phenomenon that is already taking place as labor costs in China are on the rise.

There are theoretical reasons to believe that this is an oversimplification, and may just be flat-out wrong. Suppose the dollar appreciates against the yuan but not against the Indonesian rupiah, and that low-wage manufacturing jobs simply migrate from China to Indonesia. Suppose that the loss of those low-wage manufacturing jobs in China precisely cancels out the increased purchasing power of the stronger yuan, so that China's imports from the U.S. remain unchanged. But Indonesia will be richer, because it has gained jobs! And higher Indonesian incomes, at the same dollar/rupiah exchange rate, will mean Indonesia will buy more goods and services from the U.S., boosting our exports and creating jobs in the U.S. End result: Good for America, good for Indonesia (and neutral for China).

The lesson here is that trade-weighted exchange rates are what matter. And in fact, it may be the case that other export-dependent countries keep their own currencies artificially depressed to maintain competitiveness with China, even though this forces them to acquire crappy dollar assets as government reserves. If the yuan were to get stronger, these countries would also probably feel free to let their own currencies appreciate, lowering the cost of American exports all over the world, and creating even more jobs here.

This is not rocket science. Basic economics says that price controls are inefficient, and the yuan/dollar peg is the world's biggest price control.

But don't take my word for it. Some very smart people have done serious scholarly research in this area. Take Menzie Chinn (of Econbrowser fame), whose detailed statistical analyses conclude that a rise in the value of the yuan would be good for everyone involved. Or watch Paul Krugman, a lifelong trade economist, explain the intuition. These guys cannot be dismissed with a hand-wave or a shout of "protectionism".

Anyway, here is Michael Cohen's argument why the yuan bill, now stalled in Congress by the Republican House leadership, is mere political theater:

In a way, it's surprising that it took this long for Congress to get around to making China a scapegoat for the continued U.S. downturn. After all, finding a foreign bogeyman at a time of domestic economic dissatisfaction is hardly unusual. In the 1930s, it helped spur passage of the Smoot-Hawley tariffs; in the 1980s and early 1990s, economic fears -- and high-profile investments by Japanese businesses, like the purchase of Rockefeller Center -- led to a round of Japan-bashing in popular culture and the media...

But for all the bipartisan panda-mugging going on, it's unclear that the American people are buying it quite yet. According to a recent poll by the Pew Research Center, when given an option of "getting tougher with China" or "building a stronger relationship," voters supported the latter by a 53-40 margin. Even though all but five members of the Senate Democratic caucus voted for this week's currency bill, only 32 percent of Democratic voters want to see a get-tough approach to China.

The seeming contradiction here - why would China-bashing be a good political strategy if it went against majority opinion? - implies that there is some narrow special-interest minority that is pushing both Democrats and Republicans toward a trade war. But who would that minority be? American manufacturing interests? Seems unlikely, given how much manufacturing has shrunk as a percentage of our economy during the past few decades. Unions? Ha.

In fact, it seems to me that the special-interest groups that matter are lining up against the currency bill. U.S. multinationals made record profits in the 2000s as American incomes stagnated; this increase in the "capital share of income" was made possible by the dumping of a huge, capital-poor Chinese labor force onto the global markets, making workers less scarce and capital more scarce. But that effect was exaggerated by the yuan peg, which made Chinese labor even cheaper and American capital even more expensive. Thus, it is no surprise that multinationals are putting big pressure on John Boehner to keep the currency bill from reaching the House floor; up til now they have been receiving a bigger and bigger share of an American pie that is now shrinking, and a stronger yuan might remove that lifeline.

So I am not sure why opponents of a "get tough" China policy are so cavalier about the strength of their arguments. It's not that there are no good arguments against getting tough. After all, tariffs might not budge China from its mercantilist currency stance, and the resulting trade war might very well turn into a lose-lose for both sides. Getting tough is therefore risky. But I think that the valiant Panda Knights are a little too solicitous of their fuzzy friend when they claim that the yuan peg itself is no big deal, or that Congress is in the pocket of nefarious protectionist special interests.

Update: Ryan Avent takes me to task, writing:

Noah Smith seems to imply that critics of a "get tough" approach mainly think there would be no benefit to a yuan appreciation. I readily agree that there would be some benefit to both China and America of an appreciation in the yuan. It's difficult to demonstrate that there would be substantial benefit, however. Mr Smith cites economist Menzie Chinn in support of the point that a yuan appreciation would benefit both parties. Fair enough, but Mr Chinn has also written that a dearer yuan might not lead to a big increase in Chinese imports and might not have much of an effect in the absence of a broader Asian appreciation...There is a benefit there, but it's not at all sure to be a large one.

Ryan is right that Chinn definitely does hedge his bets. But, reading Chinn's post, I take away a very different message:

The fact that yuan revaluation would not necessarily have a large impact on job creation (for that we need vigorous and immediate expansionary monetary and fiscal policy) does not mean that it wouldn’t be a (very) good thing, however...[A]ccelerated yuan appreciation would be a good thing, in that it would facilitate global adjustment of current account balances, as well as the transition to a new development model for China. Paul Krugman has forcefully argued that accelerated yuan appreciation would help US employment, based on work by Autor, Dorn and Hanson (2011) (discussed in this post), and I'm willing to be convinced.

Chinn then goes on to link to a paper of his that finds that the Chinese trade balance does respond to exchange rates in the logical fashion.

Avent goes on to repeat the strongest Panda Knight argument, which is that trying to muscle China into changing their policy is a dangerous game. I've never disputed that. I'm only arguing that in their zeal to stop America from launching a trade war, Panda Knights often rely on hand-waving arguments. If and when the currency issue becomes the focus of increased public and intellectual attention - as it soon may if Mitt Romney wins the Republican nomination - their willingness to throw the kitchen sink at their opponents may not help the Panda Knights' credibility.

Update: Ryan's co-blogger gives a welcome reminder that yuan appreciation would be great for the vast majority of Chinese people, and it is only the narrow interests of well-connected exporters that keep this from happening. When you see the Panda Knights post pictures of poor sad pandas in cages, ostensibly supposed to represent China's suffering at the hands of the U.S., recall that the people benefiting most from the yuan peg are China's 1%, not its struggling hard-working masses.

Rational Expectations vs. Heliocentrism

2011-10-15T17:12:00.002-04:00

More philosophy-of-science blogging...

It's not often that I take strong exception to a Matt Yglesias point, but today is one of those days. Discussing John Kay's epic rant against modern macro, Matt compares the Rational Expectations Revolution to the Copernican Revolution in astronomy:

The basic impulse to say that the theory has to make sense and be grounded in a compelling account of how the world works makes major contributions here. It’s why Copernicus ditching geo-centrism for heliocentrism, and it’s how Newton develops the theory of gravity. But the instinct to say that no, the important thing is for the theory to produce actual results is also important. If we’d stuck with Copernicus’s “theoretically compelling” idea about perfect circles, we’d never have noticed that this was actually a totally arbitrary modeling assumption with no basis whatsoever...What’s more, while in retrospect we see Copernicus as the ancestor of our modern way of thinking, the fact of the matter is that if you were trying to launch a rocket ship somewhere in the early 16th Century you’d be much better off chugging along with the epicycles rather than siding with the guy who knew that the earth orbited the sun.

My view, with both all due respect and all due derision, is that the Robert Lucas types are like the early Copernicans here. There’s something admirable in their insistence that it ought to all work out to an easily modeled system grounded in compelling theoretically considerations. The New Keynesian model is a mess, like late-Ptolemaic astronomy, thrown together to account for observed reality. But you don’t fly to a moon with an elegant model that delivers mistaken predictions about where the moon’s going to be. And what we actually need is a Kepler to give us an elegant model that actually predicts the phenomena, and then a Newton who can explain what that model means.

While I agree with Matt's take on how good science works (alternating steps of theoretical deduction and experimental induction), and with his take on the Copernican Revolution, I think he's being way too generous with the analogy to Rational Expectations. For two reasons:

1. Unlike heliocentrism, we don't know yet that Rational Expectations is right. It is certainly not the case that Rational Expectations is the only "easily modeled system grounded in compelling theoretical considerations." There are plenty of alternatives! The obvious candidate here is a model where people learn over time. If you don't think that's a compelling alternative, just ask recent Nobel winner Thomas Sargent; even though he helped invent Rational Expectations, when found that the RE models didn't fit the data, he started working on learning-based models instead. So until the data give us a good idea of which overarching theoretical framework (if any) describes the world, we should treat RE as only one candidate among many. It may not even turn out to have been a good guess.

2. The Rational Expectations people didn't just insist that macroeconomists use self-consistent, perfectly microfounded Theories of Everything. In fact, they didn't stop at insisting that people use Rational Expectations! They went so far as to insist that theories of business cycles should be driven by so-called "real shocks" - changes in technology, changes in government policy, or changes in people's willingness to work. These were at the heart of Ed Prescott's "Real Business Cycle" theory, which became the heart of the "freshwater" school of macro. Although New Keynesian models also use the Rational Expectations framework, freshwater types went out of their way to denigrate these demand-based models. The current insistence by political conservatives that our economic malaise is due to workers' laziness, or "policy uncertainty," or uncontrollable changes in technological progress, is given intellectual heft by the freshwater school's insistence that these are the only things that should matter. It's kind of like if Copernicans had called Kepler a "bad guy" for daring to suggest elliptical heliocentric orbits instead of circular ones.

I try not to be too hard on the Rational Expectations Revolution. It was motivated not only by theoretical elegance or ideology, but by observation of the real world - specifically, the failure of stimulative monetary policy in the 1970s. And it may well have erased a false sense of certainty among econometricians that was leading to policy mistakes (I plan to write a post about this soon). That is all to the good. But the revolution has not yet led to a theory of business cycles that fits the data well. And it very well may never do so - especially, I predict, if its adherents keep insisting on including only "real shocks" in their models. Until RE gives us something constructive, I think that comparisons with Copernicus are premature.

Update: Gregory Chow makes my first point...with real math and data!

Three cheers for Sargent & Sims, one and a half for the "Economics Nobel"

2011-10-10T20:44:00.004-04:00

Today, as you may have heard, the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, more commonly called the "Economics Nobel," went to Thomas Sargent and Chris Sims. To get some info about Sims' work, see here and here, and to get some info about Sargent's work, see here.

First, what I think about today's award (as if that matters, ha). Short version: I heartily approve.

Both of these guys are data guys - empiricists, first and foremost. Specifically, both are macro data guys, which means the difficulty of their job is somewhere between Moses and Gandalf. I have nothing but respect for anyone who manages to make any progress at all in macro empirics. And furthermore, I think that good empirics is exactly what macro needs right now; the field has had a wild proliferation of theories that describe anything and everything, with far too few efforts to prune the idea tree and isolate which of the models are really describing the world. Thus, both Sims and Sargent have, in my eyes, been fighting the good fight.

This applies to Sargent especially. Sargent is famous for "taking models seriously," i.e. testing econ models like you would test a model in physics or biology. As a result, although Sargent is typically identified with the "freshwater" or "rational expectations" school of thought, his hardheaded empiricism was actually somewhat of a thorn in the side of the original RBC guys (Lucas and Prescott), who went so far as to ask him to stop testing their models! Also, his most famous work indicated that central banks, which we usually task with stabilizing both GDP growth and inflation, might not be powerful enough to do even one of those. This is a splash of cold water for both Milton Friedman-era monetarists and for modern believers in central bank omnipotence.

So, basically, Sargent is a badass. Scientists who exert serious efforts trying to knock down their own schools of thought are usually unsung heroes, and it's good to see one of them getting recognition.

As for Chris Sims, I'm much more familiar with his work, having taken a time-series econometrics course from the eminent Lutz Killian of Michigan. Sims is best known as the inventor of the Vector Autoregression, a way of looking at data that makes as few theoretical assumptions as possible. I like this approach. VARs have fallen somewhat out of favor due to their enormous standard error bands; rare is the properly specified VAR that actually makes a strong conclusion about what the data says. But I see this as a feature, not a bug! All too often, macroeconomists claim "empirical support" from the flimsiest of hand-waving (e.g. "The correlation in the data is 1.45, my model gets 1.13, so that's pretty close."). VARs are honest about what they don't know.

So basically, I think these are great awards. However, my longstanding dislike for the "Economics Nobel" itself remains.

What people need to understand about the "Economics Nobel" is that it is not a prize for a specific discovery, like the science Nobels (medicine, physics, and chemistry). It is more of a lifetime achievement award, like the Fields Medal in mathematics. The reason this is so is that to get a science Nobel your discovery actually has to be verified empirically, while in economics, convincing empirical verification is extremely rare. So what ends up happening is that "Economics Nobels" are generally given either for A) development of new techniques and methods, or B) theories that tell interesting stories.

I have no problem with the development of new techniques and methods (it would be pretty dumb if I did!), but I think it's obvious that it's a lower bar to clear, science-wise, then what medicine Nobelists face. In biology, a new technique that leads to no new empirically verified discoveries (or demonstrably useful technologies) is just not that interesting. In economics, DSGE models won Nobels long before there was any DSGE model capable of making good macroeconomic forecasts (some would argue there still is no such model). The prize committee just thought DSGE was neat.

It's not just the prize committee that makes the decisions, though; it's the profession itself. Consensus is key. But in a field with as little empirical verifiability as macreconomics, consensus is something of a free parameter, subject to fads and herd behavior. In 40 years the profession may have completely abandoned DSGE, but Ed Prescott's Nobel will stand forever.

The shifting winds of consensus lead to the politicization of the economics award. This has been noted and criticized by prize recipients Gunnar Myrdal and Friedrich Hayek. The "Economics Nobel" confers a level of respect to the theories of the recipients that is almost on a level with that accorded by the science Nobels, but the decision process is sort of halfway between the science prizes and the Nobel in Literature. Like economics itself on its worse days, the prize is always in danger of putting a sheen of "science-y-ness" on matters of opinion.

This year, of course, the politics are fairly obvious, and I happen to agree with them completely. Macroeconomies all over the world are doing some really weird stuff. There are lots of ideas, but little consensus, about which theories we should be using to understand events like the financial crisis, Little Depression, and current relapse, not to mention globalization and China. In times like these, it is best to look to the data first. Pruning the idea tree is more important now than ever. If today's award to Sargent and Sims has a political message, it is that.

But in the long run, I think it would be better if the Bank of Sweden adopted more stringent criteria for the awarding of the prize, more akin to the criteria for the Nobel in Medicine. That may mean fewer winners - perhaps only one a year, or even some years of "no recipient." It will certainly tilt the award toward microeconomists. But so be it. If you're going to call it the "Prize in Economic Sciences," then my opinion is that you should back that up.

In the meantime, though, congratulations to today's winners. Three cheers for better macro empirics!

Baxter & King 1993: Why government spending isn't just moving money around

2011-10-04T13:43:00.004-04:00

This is the first in a series of posts called "Papers You Should Know". I believe one of the essential roles of econ blogs should be to bring research into the public consciousness. There's a ton of really interesting papers out there that get mooted in academic circles, or taught in grad classes, but whose insights never really make it into the wider discussion. That's a shame. It means that most intelligent, educated non-economists encounter a hundred worthless American Enterprise Institute hackonomics propaganda pieces for every one serious piece of scholarly research. Which, I find, often leaves people with the vague notion that academic economists spend 90% of their time glorifying the frictionless perfection of the free market, and the other 10% collecting "consulting" fees for big banks.

It isn't so. There is absolutely tons of research out there that looks at questions of how markets break down, and how complex "frictions" make interesting stuff happen. Today I'm going to look at one such paper: Marianne Baxter and Robert G. King's "Fiscal Policy in General Equilibrium" (American Economic Review, 1993).

First, for some background. One of the biggest questions for macroeconomists right now is whether government spending can boost the economy. You often hear conservative-minded economists saying that no, government spending is just "moving money around" without creating any wealth. For example, here is John Cochrane, of the University of Chicago, from 2009:

[M]oney [spent by the government] has to come from somewhere. If the government borrows a dollar from you, that is a dollar that you do not spend, or that you do not lend to a company to spend on new investment. Every dollar of increased government spending must correspond to one less dollar of private spending. Jobs created by stimulus spending are offset by jobs lost from the decline in private spending.

Where this idea really comes from is an academic paper - in fact, one of the most famous econ papers ever written. In "Are Government Bonds Net Wealth?" (Journal of Political Economy, 1974), Robert Barro (currently of Harvard) showed that under certain conditions, the timing of government spending doesn't matter for the economy. This idea, which is called "Ricardian Equivalence", is exactly what John Cochrane was talking about. In this model, government can only move economic activity around, not create it.

When I read this famous paper, I immediately found it fishy. One of the model's (unstated) assumptions is that government spending consists entirely of transfer payments - i.e., taking money from one person and handing it to another. In other words, Barro assumes that government is fundamentally different from, say, a corporation; while a corporation can invest money today to create new wealth tomorrow, government can only shuffle money around. There is no "government capital" that we can invest in today that will create new wealth down the road.

To me, this felt a bit like assuming the conclusion. If you just assume government doesn't produce anything new, of course it's going to be hard to get government spending to boost the economy! If you think that public goods can boost the economy, then everything changes. I pointed this out in a blog post back in March, and even considered writing a paper about it. Then I found out that someone had already written that paper. And those someones were Marianne Baxter and Robert G. King, in 1993.

Only scooped by 18 years. Not bad, eh?

What Baxter and King (here's the link again) do is to take your most basic neoclassical business cycle model - the RBC model - and simply add government capital. What is government capital? Well, it's any kind of capital that the private sector can't or won't build (or can't or won't build enough of). In other words, government capital is a nonrival production input, or "public good." For the math on how those work, see here. Basically, these are things like roads, electrical grids, airports, and other infrastructure. Schools and research centers and courts and police could also count.

So Baxter & King put public goods into the production function. Instead of only including private capital and labor, GDP now depends on government capital as well. Here's the equation, for those of you who like equations:

Everything else is just pure RBC - no frictions, no sticky prices, no sticky wages, no financial sector, no nuthin'. Exactly the way Ed Prescott would like it, except for that little KG thing there on the end.

And of course, what happens? "Ricardian equivalence" goes straight out the window! If the government can invest in useful projects just like a firm, then the timing of government spending matters a lot, just like the timing of private investment. Baxter & King find that, in their model, government spending has a huge "multiplier", even with none of the Keynesian stuff like sticky wages.

But this is hardly surprising. Like I said, Barro starts with the assumption that government spending is 100% transfers. It's almost painfully obvious that if you allow for government to actually build useful things, you're going to get a very different result. In fact, while giving full props to Baxter & King, I'm a little surprised it took until 1993 for people to do this.

So, do the data support Baxter-King? Well, the short answer is that I need to look into this a lot more. But here is an interesting paper by Michigan's own Rudi Bachmann, along with Eric Sims of Notre Dame, that shows that when the government invests more money, especially during downturns, it raises business confidence. The last line from the abstract basically says it all:

In particular, spending shocks during downturns predict future productivity improvements through a persistent increase in government investment relative to consumption, which is in turn reflected in higher measured confidence.

Which is exactly what you'd expect from Baxter-King.

Now let's return to the present debate over government spending. Most of that debate revolves around things like liquidity traps, sticky wages, business confidence, and so on. But if we live in a Baxter-King world (or a Bachmann-Sims world), the case for more spending is actually a lot simpler. We desperately need to repair our country's infrastructure. Only government will do that. Interest rates are historically low, meaning that now is the perfect time to borrow money to rebuild the roads. Doing so would raise employment today, but because roads are necessary for tomorrow's businesses to thrive, it would also raise GDP in the future. It's not just a slam dunk, it's a free lunch!

There is, of course, a caveat here. Government capital has its limits. As Japan proved when it concreted over its rivers and built bridges to nowhere in the 1990s, you can reach a point where more infrastructure is just inefficient (something that Baxter & King, notably, do not allow for in their model). But I would argue that, given the dilapidated, crumbling nature of America's roads and bridges, we are not anywhere near that point.

So to sum up: Baxter & King (1993) show that it's very easy to get government spending to matter in a big way. All you have to do is assume that public goods exist. Every time you hear someone say that "the money [for stimulus] has to come from somewhere!", just tell them that the money will come from the future wealth that private businesses will create once they can ship goods to each other over our shiny, new, government-built roads. Or just say "Baxter & King, 1993".

"Industrial Complexes" and the Great Relocation

2011-10-02T21:27:00.002-04:00

Paul Krugman created the theory that inspired my Great Relocation idea, so perhaps it's natural for him to invoke it regarding Congress' latest attempt to get tough on China's currency policy. But in any case, I am really glad to see him bring it up:

I though I should offer a brief note about one of the arguments people make against focusing on Chinese currency manipulation — namely, the claim that China doesn’t really compete head to head with US manufacturing, so that a rise in the renminbi wouldn’t help.

I’d argue that this is wrong...

[T]here are real effects on the US if production moves, say, from China to Mexico. To an important extent, global manufacturing is carried out by regional complexes — an Asian complex centered on Japan and China in effect competes with a North American complex in which labor-intensive stuff is done in Mexico or Central America. So there’s an indirect competitive effect.

This is exactly the Great Relocation story. An "industrial complex" is a cluster of suppliers that represent different levels in a value chain. Transport costs, broadly defined - including costs from the necessity for face-to-face contact with customers, the ability to hire people away from one's competitors, and local knowledge spillovers - are minimized when all the firms locate close to one another. This is what creates industrial clusters.

Look around the world, and you will see that industries tend to cluster. Electronics is centered in East Asia. Business services and software are centered in India and on the U.S. West Coast. Finance is in Britain and on the U.S. East Coast. Heavy industry is in Germany. Not exclusively, obviously, but the clusters are real.

These clusters raise productivity, by minimizing (broadly defined) transport costs. If I am a builder of televisions, it makes sense to locate in Japan or Korea, because there I will be close to many high-quality television parts suppliers. And it also makes sense for me to locate in Korea or Japan, because the existing cluster of TV manufacturing in that region provides me with a pool of knowledgeable employees to hire away from my competitors. And even if I don't hire them away from my competitors, they will meet my own employees in bars, and at trade associations, and socially, and they will exchange ideas (read Annalee Saxenian's Regional Advantage to find out why this was important in the development of Silicon Valley). All of those things increase both my productivity, the productivity of my suppliers and customers, and even the productivity of my competitors. In other words, the entire cluster gets a productivity boost from being a cluster. And high-productivity firms defeat low-productivity firms.

So what Krugman is saying is that the Chinese currency policy is holding Latin America back from developing its own industrial clusters. And that is indirectly holding back American manufacturing, because Latin American clusters are going to have more exchanges of products, ideas and people with the U.S. than clusters in East Asia.

Which is why one way of fighting the Great Relocation is to fight China's currency policy. Natural forces will eventually make densely-populated East Asia the world's ~~high-tech~~ biggest manufacturing hub. But there is no reason we should let Chinese government policy speed up that transition.

Science is about discarding models, not making them

2011-09-29T18:21:00.005-04:00

As someone who is preparing to apply for jobs as a professional economist, I can't help feeling down when I see Paul Krugman write something like this:

I’ve never liked the notion of talking about economic “science”...Still, when I was younger I firmly believed that economics was a field that progressed over time, that every generation knew more than the generation before.

The question now is whether that’s still true...I think you can actually make the case that in important ways the profession knew more in 1971 than it does now...

[M]any economists aren’t even trying to get at the truth. When I look at a lot of what prominent economists have been writing in response to the ongoing economic crisis, I see no sign of intellectual discomfort, no sense that a disaster their models made no allowance for is troubling them; I see only blithe invention of stories to rationalize the disaster...

And all this makes me wonder what kind of an enterprise I’ve devoted my life to.

Paul Krugman is one of my personal heroes; it was the brilliance of his theories that lured me to the profession in the first place. So it makes me pretty sad to hear him questioning the value of the whole enterprise.

But I can't really disagree with his characterization. There's a reason you keep seeing these "is economics a science?" posts popping up around the blogosphere. The crisis made a lot of people question the value of economics, in its current form, as a useful tool for understanding and affecting the world. But when many economists seemed not to experience similar doubts, it raised the question of whether the profession approaches the world in a scientific way.

About 400 years ago, see, humans discovered a new way of understanding and interacting with the world, which seemed to work a lot better than what we had been doing before. The new approach involved things like doing experiments, writing down models, and observing the natural world. But what exactly was so great about this approach, which we called "science"? What were the key features of this new approach that made it so much more effective? If we have the models without the experiments, or vice versa, will we still get the same results?

I believe that we - some of us, anyway - have had a good answer to this question for a long time. The answer is that science works when it has a way to discard ideas that do not work. People have phrased this answer in different ways. Francis Bacon called it eliminative induction. Karl Popper called it "falsifiability." Richard Feynman called it "doubt." But it's the same idea. You actively look for what doesn't work, and throw it out.

Economists, I think, do not always see this as the essence of science. For example, here is Scott Sumner, in March 2011:

I’ve always thought that the debate over whether economics is a science is actually a debate about the meaning of the term ’science.’ If science is when people build models to better understand the world around us, then economics is a science.

And here is Stephen Williamson:

I looked up a definition of "science," and came up with this:

The intellectual and practical activity encompassing the systematic study of the structure and behavior of the physical and natural world through observation and experiment.

So, as economists we are systematic, we study the structure of the economy and the behavior of individuals in it, and we observe and experiment. Thus, apparently, we are a science.

Now, far be it from me to argue with the Oxford English Dictionary. But I contend that the real question here is substantive, not semantic. Whether or not an object is an "airplane," the important question is whether it flies. And whether or not economics is a "science," the important question is whether or not it discards its bad ideas.

Economics has several ways of discarding bad ideas. The most common is to use empirical data to reject models. One particularly effective way of doing this is to use "natural experiments". A second method is to use experiments, which can be laboratory experiments or field experiments.

So, procedurally, economics is a science.

But there is a difference between what a field can do and what it does do. A field is not just a set of techniques, it is also an established culture that chooses when and how to use those techniques. It is in this sense that economics does not always live up to its potential as a science.

What I am not talking about are models that are that non-testable. Economics does make some of these, but that's fine. These models may be interesting as pure mathematics, or they may be of use in doing future science, even though they themselves are not science. I don't lose any sleep over these.

What bothers me is that the economics profession, as a culture, does not always insist that the testable models be tested and discarded. When enough economists ignore the facts and keep believing in models that can and should be discarded, then even though economics is procedurally a science, culturally it is not behaving like one. Obviously, I am referring to most of the popular macro models in use before the crisis.

So I disagree very strongly with Scott Sumner. The heart of science is not building models, but discarding them. Economics as a discipline has the tools to prune its tree of models, but economics as a culture has not been using these tools harshly enough. And so we've ended up as a sort of massive supermarket of models, where we have a model (or twenty models) for any conceivable phenomenon, but little way of knowing which model we should use in which situation. Economists who protest that "we had plenty of models that described financial crises" can't answer the question of why nobody was paying attention to those models before the crisis slapped us in the face.

This, I believe, is why the public has become incredibly skeptical of our profession. We let ourselves get away with too much. When we saw data that flatly contradicted our favorite theories, we just shrugged and kept on believing. And many of us seem still to be doing this, even now. And that is why these philosophy-of-science blog posts keep coming and coming. As well they should.

(Note: Most of what I'm complaining about here, like much of what I write on this blog, really goes only for macro. Micro, which is just a lot easier to test, is generally much better about being "scientific." But the difficulty of testing macro models doesn't let the field off the hook...)