LARS P. SYLL

Macroeconomic foundations made of sand

Olivier Blanchard, the IMF’s chief economist, recently wrote:

“We in the field did think of the economy as roughly linear, constantly subject to different shocks, constantly fluctuating, but naturally returning to its steady state over time. Instead of talking about fluctuations, we increasingly used the term “business cycle.” Even when we later developed techniques to deal with nonlinearities, this generally benign view of fluctuations remained dominant.”

The models that macroeconomic practitioners developed reflected this essentially linear view. Blanchard went on to observe that although macroeconomists did not ignore the possibility of extreme tail risk events, they regarded them as a thing of the past in developed countries … If you get the policy settings right, linear models will work.

Except that they won’t. And that is because these models are not realistic views of how the economy actually works. Representative agents aren’t actually representative of anyone. Rational expectations are driven as much by emotion as logic …

Leaving banks out of economic models, or – worse – modelling their money-creating function incorrectly, made it impossible for mainstream economists to understand the significance of the build-up of credit that led to the financial crisis. The warnings came principally from people outside mainstream economics, particularly the followers of Hyman Minsky. After the crisis, Minsky’s “financial instability hypothesis”, long consigned to a dusty shelf in a dark cupboard, suddenly became hot news. Unsurprisingly, since we had just lived through something that looked very like a “Minsky moment”.

Clearly, the exclusion of the financial industry from models of the macroeconomy was a major omission. Equally clearly, the fact that most macroeconomists did not, and to a large extent still do not, understand the mechanisms by which money is created and circulated in the modern monetary economy, is a big, big problem. Central banks are now “adding” the financial sector to existing DSGE models: but this does not begin to address the essential non-linearity of a monetary economy whose heart is a financial system that is not occasionally but NORMALLY far from equilibrium. Until macroeconomists understand this, their models will remain inadequate …

Some of the most influential people in macroeconomics have spent their lives developing theories and models that have been shown to be at best inadequate and at worst dangerously wrong. Olivier Blanchard’s call for policymakers to set policy in such a way that linear models will still work should be seen for what it is – the desperate cry of an aging economist who discovers that the foundations upon which he has built his career are made of sand. He is far from alone.

Frances Coppola

‘How I became a Keynesian’

Until [2008], when the banking industry came crashing down and depression loomed for the first time in my lifetime, I had never thought to read The General Theory of Employment, Interest, and Money, despite my interest in economics … I had heard that it was a very difficult book and that the book had been refuted by Milton Friedman, though he admired Keynes’s earlier work on monetarism. I would not have been surprised by, or inclined to challenge, the claim made in 1992 by Gregory Mankiw, a prominent macroeconomist at Harvard, that “after fifty years of additional progress in economic science, The General Theory is an outdated book. . . . We are in a much better position than Keynes was to figure out how the economy works.”

We have learned since [2008] that the present generation of economists has not figured out how the economy works …

Baffled by the profession’s disarray, I decided I had better read The General Theory. Having done so, I have concluded that, despite its antiquity, it is the best guide we have to the crisis …

It is an especially difficult read for present-day academic economists, because it is based on a conception of economics remote from theirs. This is what made the book seem “outdated” to Mankiw — and has made it, indeed, a largely unread classic … The dominant conception of economics today, and one that has guided my own academic work in the economics of law, is that economics is the study of rational choice … Keynes wanted to be realistic about decision-making rather than explore how far an economist could get by assuming that people really do base decisions on some approximation to cost-benefit analysis …

Economists may have forgotten The General Theory and moved on, but economics has not outgrown it, or the informal mode of argument that it exemplifies, which can illuminate nooks and crannies that are closed to mathematics. Keynes’s masterpiece is many things, but “outdated” it is not.

Richard Posner

On prices and profits

Much recent discussion about potential price inflation seems to take as a given that it would be sparked by a pickup of wage growth. But looking at data from the non-financial corporate sector–which accounts for well more than half of all private-sector economic activity and for which rich data are available–what’s really striking about price growth since the end of the Great Recession is how much of it has been driven by risingprofits, not rising labor costs. In fact, labor costs have been essentially flat between the end of the Great Recession and the first quarter of 2014. Profits earned per unit sold, on the other hand, have been rising at an average annual growth rate of nearly 9% since the recovery’s beginning. To the degree that there is any inflationary pressure in the U.S. economy over that time, it is surely not coming from labor costs.

Josh Bivens

Game of chicken

The truth about relativity

What if you are single, and hope to appeal to as many attractive potential dating partners as possible at an upcoming singles event? My advice would be to bring a friend who has your basic physical characteristics (similar coloring, body type, facial features), but is slightly less attractive (—you). Why? Because the folks you want to attract will have ahard time evaluating you with no comparables around. However, if you are compared with a “-you,” the decoy friend will do a lot to make you look better, not just in comparison with the decoy but also in general, and in comparison with all the other people around. It may sound irrational (and I can’t guarantee this), but the chances are good that you will get some extra attention.

Of course, don’t just stop at looks. If great conversation will win the day, be sure to pick a friend for the singles event who can’t match your smooth delivery and rapier wit. By comparison, you’ll sound great.

Now that you know this secret, be careful: when a similar but better-looking friend of the same sex asks you to accompany him or her for a night out, you might wonder whether you have been invited along for your company or merely as a decoy.

Great book that ought to be on every economist’s reading list.

Lucas’ bridge and the Ricardian equivalence fairy-tale

Imagine a Nobel Prize winner in physics, who in public debate makes elementary errors that would embarrass a good undergraduate. Now imagine other academic colleagues, from one of the best faculties in the world, making the same errors. It could not happen. However that is exactly what has happened in macro over the last few years.

Where is my evidence for such an outlandish claim? Well here is Nobel prize winner 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.  There’s no reason to expect any stimulation.  And, in some sense, there’s nothing to apply a multiplier to.  (Laughs.)  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 here  is John Cochrane, also a professor at Chicago, and someone who has made important academic contributions to macroeconomic thinking:

“Before we spend a trillion dollars or so, it’s important to understand how it’s supposed to work.  Spending supported by taxes pretty obviously won’t work:  If the government taxes A by $1 and gives the money to B, B can spend $1 more. But A spends $1 less and we are not collectively any better off.”

Both make the same simple error. If you spend X at time t to build a bridge, aggregate demand increases by X at time t. If you raise taxes by X at time t, consumers will smooth this effect over time, so their spending at time t will fall by much less than X. Put the two together and aggregate demand rises.

The more interesting question for me is why the errors were made … I want to suggest two answers. The first is familiarity with models. I cannot imagine anyone who teaches New Keynesian economics, or who talked to people who teach New Keynesian economics, making this mistake … The second difference between physics and macro that could lead to more mistakes in the latter is ideology … When you are arguing out of ideological conviction, there is a danger that rhetoric will trump rigour … The problem too many macroeconomists have with fiscal stimulus lies not in opposing schools of thought, or the validity of particular theories, or the size of particular parameters, but instead with the fact that it represents intervention by the state designed to improve the working of the market economy. They have an ideological problem with countercyclical fiscal policy. But the central bank is part of the state, and it intervenes to improve how the economy works, so this ideological view would also mean that you played down the role of monetary policy in macroeconomics. So ideology may also help explain a lack of familiarity with the models central banks use to think about monetary policy. In short, an ideological view that distorts economic thinking can lead to mistakes.

Simon Wren-Lewis

In case your not yet persuaded, here’s another blog post describing what goes wrong  when people like Robert Lucas and those with similar views apply their models based on Ricardian equivalence:

[T]hink about what happens when a family buys a house with a 30-year mortgage.

Suppose that the family takes out a $100,000 home loan (I know, it’s hard to find houses that cheap, but I just want a round number). If the house is newly built, that’s $100,000 of spending that takes place in the economy. But the family has also taken on debt, and will presumably spend less because it knows that it has to pay off that debt.

But the debt won’t be paid off all at once — and there’s no reason to expect the family to cut its spending right now by $100,000. Its annual mortgage payment will be something like $6,000, so maybe you would expect a fall in spending by $6000; that offsets only a small fraction of the debt-financed purchase.

Now notice that this family is very much like the representative household in a Ricardian equivalence economy, reacting to a deficit financed infrastructure project like Lucas’s bridge; in this case the household really does know that today’s spending will reduce its future disposable income. And even so, its reaction involves very little offset to the initial spending.

How could anyone who thought about this for even a minute — let alone someone with an economics training — get this wrong? And yet as far as I can tell almost everyone on the freshwater side of this divide did get it wrong, and has yet to acknowledge the error.

Paul Krugman

Indeed — how can anyone get this wrong and make such ridiculously simple errors when arguing about fiscal stimulus?

Fiscal policy is not irrelevant. Ricardian equivalence is.