Wednesday, July 2, 2014

Macro debates


Wall Street Journal Op-Ed, on supply vs, demand in understanding slow growth.

The underlying paper is The New Keynesian Liquidity Trap, for those wanting more substance to some of the claims about New Keynesian models.

They didn't want the graph, but I think it illustrates the point well.

Please follow the link for the oped itself.

44 comments:

  1. Most excellent essay!

    “For policy, the central fact is that Keynesian policy recommendations have
    no sounder basis, in a scientific sense, than recommendations of non-Keynesian
    economists or, for that matter, non economists.” - After Keynesian Economics (aka After the Phillips Curve): Persistence of High Inflation and High Unemployment, Lucas and Sargent, pg. 57.


    http://www.bos.frb.org/economic/conf/conf19/conf19d.pdf

    ReplyDelete
    Replies
    1. Change a few nouns in that quote and you describe the current debate about "climate change".

      The problem with these quasi-scientific debates is that these are areas where the conventional scientific method fails. You can't test your hypotheses, you can't test the predictive quality of theories, and you can't re-run history to see if you can reproduce the results.

      Take a lesson from the engineers. They run a model and then test it against empirical reality. They never match, and the engineers have to add in some fudge factors to make the model practical. Because reality is messy. You can't just stop at the model.

      Unfortunately, some areas of human endeavor don't lend themselves well to either scientific or empirical testing. You have to figure out how the motor works while it's running, and try to fix it while it's running.

      Delete
    2. Mr. McMunn clearly doesn't understand the construction and role of modeling in science. I don't know much about economics, but in the case of climate modeling, the models are constructed from physical principals and the inputs are actual measurments. The testing is done with historical or experimental data, which must agree or the model is considered inadequate and must be modified or changed.

      In the case of climate change there are a number of ways that theory is put to the test in actual physical experiments. Preductions of sea water pH changes can be tested experimentally in models of sea water and coral reefs. See for example: http://coastal.er.usgs.gov/crest/research-themes/community-metabolism.html

      Plant scientists have investigated the effects of accumulating atmospheric CO2 levels in growth chambers, greenhouses and field experiments. Reproductive biomass growth (edible fruit, seed) as well as vegetative biomass growth (roots, stems, leaves) are usually increased by elevated CO2. However, the harvest index, or the ratio of seed yield to above-ground biomass yield, is typically lower under elevated CO2 conditions. (see: http://www.fao.org/docrep/w5183e/w5183e06.htm) Elevated atmospheric CO2 actually reduces plant growth in combination with higher temperatures, increased precipitation or increased nitrogen deposits in the soil. (See: http://news.stanford.edu/pr/02/jasperplots124.html and http://www.newscientist.com/article/dn11655-climate-myths-higher-co2-levels-will-boost-plant-growth-and-food-production.html#.U7fzN7Elmkw)

      Engineers may add "fudge factors", but they always try to err on the side of caution, adding traditional safety factors to their designs. When the safety of the entire planet is at stake, we must do likewise.

      Delete
  2. Hail government investment! Has any sane person ever thought this wrong, timing aside? Would that work though increased demand now or expected increased supply later? The wonderful thing is that it wouldn't matter!

    ReplyDelete
    Replies
    1. That idea has been advocated a thousand times before and no matter how many times the flaws in the idea is pointed out, advocates of the idea just keep coming. The first flaw is that “government investments” normally take a fair amount of time to get going, and by that time the recession may be over.

      Moreover, there has to be some OPTIMUM amount of government investment relative go GDP, and that optimum amount ought to be being made ANYWAY, recession or no recession. To that extent, there is no reason to expand government investment in a recession any more than any other form of spending (public or private).

      Delete
    2. Prove that there is an optimum amount of public investment, and prove that that amount does not change during recessions vs during non-recessions.

      Of course, the real issue is not whether or not there is a recession. The real issue is whether or not there is sustained high unemployment -- that is, slack capacity that is being underutilized.

      Delete
  3. I guess the CBO will revise downward the potential GDP around the crisis and maybe up around today or next future; sort of mimic 2000 path

    ReplyDelete
  4. David Glasner's response says all that needs to be said:

    http://uneasymoney.com/2014/07/02/john-cochrane-on-the-failure-of-macroeconomics/

    ReplyDelete
    Replies
    1. I think Glasner needs to take a deep breath, we can all be affected by rhetoric, so his treating of rhetoric with rhetoric is to be expected and fine

      ...but his irrelevant rant on inflation, delusion that that old Keynesian models make more accurate predictions than new keynesian models, and his inability to correctly use reference material...all leave me severely disappointed

      Delete
    2. Many things to say about his article, but just two I think are very important. You don't need to prove that lower taxes and lower regulations are good, unless you don't believe that people own their time and money. The burden is on the people who want to spend trillions of dollars from tax money.
      Also, he asks for evidence, saying that since the GDP growth in the 80's started before the comprehensive tax reform of 1986 somehow the dramatic increase in GDP growth in the Reagan era had nothing to do with reducing uncertainty. But the sole election of Reagan, with his whole team of supply sider advisers in itself represented a dramatic drop in uncertainty, even before he could enact any policy. You don't get more anti Keynesian that Art Laffer. If there is one evidence against Keynesianism is the Reagan decade.

      Delete
    3. Reagan was one of America's greatest Keynesians! Just look at all the demand he added to the economy through his supply-side tax cuts and stimulative defense spending. Unfortunately for us, the money that he threw away had no long-term benefits for the economy like infrastructure improvements. Hell, even the Navy dumped his recommission battleships as soon as they could...

      Delete
    4. And Volcker did not establish his inflation controlling bona fides until 1981. Anonymous is a fan of a cartoon version of Reagan, rather than the actual President.

      Delete
  5. "Well, maybe they're right. Social sciences can go off the rails for 50 years. I think Keynesian economics did just that. But if economics is as ephemeral as philosophy or literature, then it cannot don the mantle of scientific expertise to demand trillions of public expenditure."

    Economics and economic policy is not like music, philosophy or literature. It is more like political science and, for example, foreign policy. It requires highly informed but necessarily subjective judgement - in foreign policy there is probably even more at stake than economic policy. Believe me WMDS are more powerful instruments than OMOS - however many trillions. Judgement based on informed analysis is sometimes where intelligence comes in.

    People do not bemoan the use of mathematics in economics. It is the degree to which it is used. What people in particular dislike is the scientific pretence. Steady-state or rational expectations based frameworks for analysis do not make things scientific. (A steady state assumption, for example, is a non-starter for an historian.) There is no substitute for well-informed historical and other such analysis. In the age of the internet there is no excuse now, huge amounts of information from past experience is easily accessible. A lot of information has been made available from other social scientists who are literally active in the fields, factories and other parts of the real and other economy. There are a lot of crises to examine, including many eerily like our own. The information on these is now ready to access. But it involves understanding a lot about context, such as institutional and geopolitical context. This involves opening up the discipline to others, and being receptive to their findings - and not forcing it into incompatible intellectual frameworks -"models" - unless ontologically well defended. This has the sort of aspect that has been neglected in much of modern macro-economics and where interdisciplinary discussion is needed. This is where the folly lies.

    ReplyDelete
    Replies
    1. Point being made here: the stakes of foreign policy decisions are even greater than those of macro-economics. But nobody says that international relations should be analysed with an optimisation framework. And most certainly it should not be solely analysed through such a framework.

      Delete
  6. Thanks John, very interesting post (I felt compelled to tweet the 'going off the rails' sentence). I'm hoping when you have time you will comment on the BIS 2014 Report, which I personally regard as a 'yes we can' breath of fresh air. Yellen and Wolf have already said 'no we can't'.

    ReplyDelete
  7. When a economist only see distortions where the money is (only taxes on the rich are distortionary), instead of (for example) student loans, we can all agree his or her macroeconomics is not science.

    And why doesn't John Taylor worry about the uncertainty induced by seat-of-the-pants policy on prospective students and young people thinking about forming new families and buying a home? And, he most certainly does not.

    As that great scientist Yogi Berra said, you can see a lot just by looking

    ReplyDelete
    Replies
    1. I only let this through to respond. It is insulting and ignorant to write about what john Taylor does or does not worry about. How do you know? I would bet he's first to worry about human capital investments. Leave insulting others morals and intelligence to the other blogs

      Delete
  8. John,

    "The demand side initially cited New Keynesian macroeconomic models. In this view, the economy requires a sharply negative real (after inflation) rate of interest. But inflation is only 2%, and the Federal Reserve cannot lower interest rates below zero. Thus the current negative 2% real rate is too high, inducing people to save too much and spend too little."

    Where to begin? Assuming that you want private lenders and borrowers at any interest rate, both parties must be acceptable to the terms of the loan. And so a "sharply negative" real interest rate will not hold up - see:

    http://research.stlouisfed.org/fred2/graph/?g=EKa

    Second, here is the personal savings rate:

    http://research.stlouisfed.org/fred2/series/PSAVERT

    From 1980 to 1990 the personal savings rate never dropped below 7.5% with very strong real economic growth and high real interest rates. Now it is at less than 5% after falling below 2.5% during the Bush administration.

    "Without growth, our government's already questionable ability to pay for...its debt evaporate."

    A government can swap debt for equity or sell equity and pay back bondholders if a direct swap is not feasible. It's got nothing to with the government's "ability" to pay for it's debt. It comes down to a government's willingness to substitute good policy for bad policy.

    ReplyDelete
  9. I feel like we aren't much closer to trimming NK equilibria than we were 10 years ago...I guess the FTPL is one way...but with a passive fiscal authority what path is the economy supposed to be following?

    ReplyDelete
  10. Professor Cochrane,

    I'm sure you must know that there is a decent amount of empirical evidence consistent with the demand side thesis, and inconsistent with the uncertainty thesis. For example the work by one of your colleagues, Amir Sufi (with Atif Mian). I think the (implicit) suggestion in your article that demand and uncertainty theses were on equal footing in terms of evidence is not an accurate description of the literature. For example, see these papers: http://www.frbsf.org/economic-research/publications/economic-letter/2013/february/aggregate-demand-state-level-employment/ and http://faculty.chicagobooth.edu/amir.sufi/MianSufi_WhatExplainsUnemployment_Nov2011.pdf

    ReplyDelete
  11. Hi John, you said: "The reaction in policy circles to these problems is instead a full-on retreat, not just from the admirable rigor of New Keynesian modeling, but from the attempt to make economics scientific at all."

    As an actual scientist, I put up a good-natured inter-professional challenge: Produce a graph with an empirical measure of the price level and a theoretical curve.

    http://informationtransfereconomics.blogspot.com/2014/07/a-challenge-to-macroeconomists.html

    I've put together a pretty decent model of world economies based on information theory. It says Keynesian economics is valid in certain regimes and the quantity theory of money is valid in others (see here or here).

    PS RE: climate science, the basic mechanism of the greenhouse effect was worked out by Joseph Fourier in the 1800s. You could ask a physicist, chemist, geologist or meteorologist in the 1930s what would happen if CO2 levels increased and get the right answer. That's the difference you get with a real scientific approach.

    ReplyDelete
    Replies
    1. Jason,

      That physicist, chemist, geologist, or meteorologist would probably preface his claim by saying "All else being equal". Except, all else is not equal:

      http://en.wikipedia.org/wiki/Milankovich_cycles

      And so as a government, what should it do about climate change? Should it tell people to stop burning fossil fuels until the next ice age starts to arrive and then change course? I think that was John's argument - what (if anything) should government do about climate change, not the scientific validity of one piece of climate science.

      Delete
    2. Jason, I've seen you criticize the concept of "expectations" as the phlogiston of economics, but mostly in Market Monetarist circles. While reading John's post here I got the impression that he might be using "uncertainties" in a similar (but opposite polarity) way. The words are easy to relate: strong expectations sounds like the opposite of high uncertainty. Do you suppose the attraction of both terms to macro theorists is that they're tough to quantify, and thus naturally resistant to falsification?

      Delete
    3. Frank,

      The time scale of Milankovich cycles are on the order of 10s of thousands of years which you would be able to see by looking at the link you provided. Global warming is happening 100 times faster.

      It's a bit like worrying about the Coriolis forces when you're in the middle of a car accident.

      And coordination problems are precisely problem set that government was designed to deal with. If governments aren't supposed to deal with global warming then no one is.

      Tom,

      Yes. "Uncertainty" as an effect on the economy appears immune to falsification.

      Delete
  12. Excellent essay. Especially (in addition to "though Washington seems to have forgotten about it") the bottom line, that we need don't need (so-called) stimulus but rather to fix "our tax code, our cronyist regulatory state, our welter of anticompetitive and anti-innovative protections, education, immigration, social program disincentives, and so on."

    ReplyDelete
    Replies
    1. How is any of that going to create demand?

      Delete
  13. http://noahpinionblog.blogspot.com/2014/07/cochranes-thoughts-on-recession-and.html

    Thoughts?

    ReplyDelete
    Replies
    1. I think Noah makes some excellent points. I especially liked this part:

      "But there is also the issue of parsimony. Cochrane writes: "These [policy] problems did not cause the recession. But they are worse now, and they can impede recovery and retard growth." I think people naturally see the recession and the recovery as one single phenomenon, and tend to prefer explanations in which there is only one cause for both. If you have two completely separate explanations - one for the recession and one for the slow recovery - you're adding a lot of free parameters to your model. In general, model complexity should be penalized, as with some sort of information criterion. So that's another reason I think people are skeptical of the Cochrane/Taylor/Mulligan/Prescott/Baker/Bloom/Davis thesis."

      Delete
    2. Jefftopia, I especially liked this comment by foosion:

      "Uncertainty is a wonderful explanation. Given that there's always uncertainty and that there's no good quantification, it can explain everything and can be used as a policy justification for anything. Things I like reduce uncertainty, things I don't like increase uncertainty. Who needs models when I can just ask myself what the issue in question does to uncertainty."

      For example, just the fact that macroeconomists publicly disagree with each other could be increasing uncertainty and thus causing structural problems. Maybe blogs themselves are part of the problem!

      Delete
    3. I agree, explicit models of uncertainty would be more honest intellectually, but then we would have to microfound them ;)

      Delete
  14. PierGiorgio GawronskiJuly 3, 2014 at 10:39 PM

    If u think potential gdp has fallen so much that there is no more (not much) spare capacity left in the economy, then you are saying that (1) Americans became lazy in the last 6 years (2) an inflation outburst is imminent (3) long term real interest rates are high (4) Europe (structural reforms and no stimulus) is doing fine... oh wait! But aren't these your same predictions/prescriptions of the last 6 years? Why were they so wrong for so long? Why has potential gdp fallen so sharply since 2009, if not for a lack of demand? If the demand shortfall was the cause, why did you long oppose demand-side policies that would have avoided potential gdp destruction? Finally, you may want to notice, one day, that 'old' keynesias economists introduced equations in economics, starting with Hicks and Samuelson. And PK hinted to the abuse of equations for the sake of mere internal consistency of the models, when assumptions are inconsistent with empirical evidence: don't u think misreporting opponents' thinking is etically miserable?

    ReplyDelete
  15. One Unqauntifiable Factor The Keynesians & Their Models Completely Miss Is Uncertainty. Uncertainty Has a huge negative effect on markets it's organic, you can't define it in numbers. Obama & The Feds Policies Change Daily & Quarter by Quarter. Obamacare adds even more uncertainty, employers don't know what one employee will cost let alone their workforce. Consumers are holding onto whatever they have for similar reasons. Average folks don't feel reassurance or stability.

    ReplyDelete
    Replies
    1. Have another look at the General Theory or on the 1937 QJE article dealing with uncertainty. The General Theory was very much about uncertainty. In fact uncertainty is the reason you get permanent disequilibrium in the labour markets, not sticky prices. This is also the major point made about Minsky in his re-reading of the General Theory.

      Delete
  16. John,

    Do you have any thoughts on the extent to which experiences from other countries lend support to your view or the demand story?

    Based on personal observation, I must admit to being somewhat skeptical of the explanations you mention (uncertainty, distorting taxes, etc.) I come from Denmark (where I work as an economist at a government institution) where the recovery has also been weak, in fact much weaker than the US recovery. The Danish government has embarked on a rather ambitious agenda of "structural reform", much of which has been focused on increasing the labor supply, e.g. by cutting in half the period in which people are eligible for unemployment benefits. To my knowledge, there are few complaints about uncertainty about policy, cronyism, lack of reform, and so on, yet the recovery has still been agonizingly slow.

    That, of course, does not necessarily imply that inadequate demand is the cause either. I don't claim to know what the cause is, only that the alternative explanations you cite seem like unlikely culprits. Household indebtedness is very high, though, and perhaps that is a relevant factor. (I haven't read House of Debt by Sufi and Mian yet, but my understanding is that they link the slow recovery to indebtedness.)

    ReplyDelete
  17. I liked this comment from Benjamin Cole (sometimes guest poster for Marcus Nunes).

    ReplyDelete
    Replies
    1. I didn't find it that useful. All the points he raises are addressed in the linked paper new Keynesian liquidity trap.

      Delete
  18. Dear Professor,

    I would like to ask a question - sorry if it is silly or badly formulated, I am still glad if you just could clarify me (that is, a non economist) on the subject.
    My question is this: it is obvious and you rightfully point it out frequently in your blog that the government, in general, is not in a position of sufficient competence, knowledge, readiness, or impartiality, to determine what is the right quantity of goods that should be produced, or more precisely the quantity which the market collectively desires. The government would not do a good job if it had to set how many cars should be made in a given year, to me this is quite evident. It could get the number too high, and the cars would remain unsold, or too low, and their price would rise and there would be shortages; by checking if this happens one can diagnose that the government would have done a bad job setting that number.

    I was thinking that therefore one should expect that this also be the case with the particular good that is money. However the amount of circulating money is set by the government, not by market forces in some stock exchange. So, is it possible that there is a mismatch between the quantity of money that the market, collectively, would like to be in circulation, and the quantity that the government actually puts in circulation? Is there a method to diagnose how badly the government has missed the target of the market's desired quantity of money? For example, I suppose that if too much money circulates inflation would rise, and if too little is printed people would hoard it and not spend - a money shortage.

    So, how can one diagnose if the government has done a good or bad job setting the amount of money to be produced this year? If it has printed too much or too little? What is important to look at to distinguish between these two cases, and how does this latest period fare?

    I am grateful if you cand find the time to expain in easy terms to a non-economist, and sorry in case the question is more ignorant than I can even realize.

    M.S.

    ReplyDelete
    Replies
    1. My 101 attempt

      There are various measures of money, money does not only consist of notes and coins. The government (or its central bank) controls monetary tightness or looseness through influencing the credit creation of banks. Since WWII this has been done in many countries through central bank purchases of mainly oovernment securities which influences the overall demand for credit and the interest rate. Fiscal and Monetary policy are therefore linked..In recent years there has been a return to the central bank monetization of private debt.

      Delete
  19. Well, I thought my comment was useful!

    BTW, the Dallas Fed just put out a study, more or less conceding it is fiscal policy that counts when "preserving" price stability.

    The Dallas Fed report is entitled "Inflation Is Not Always and Everywhere a Monetary Phenomenon," authored by Antonella Tutino and Carlos E.J.M. Zarazaga.

    They seem to be saying some of the things you said at the Hoover bash.

    Hey, I would be happy to pay down national debt through QE and balance the federal budget. I think that is a great game plan.

    I will try to read your paper on the The New Keynesian Liquidity Trap. But remember, I am only an intelligent layman, and my wife questions to intelligent part!

    Cohen=Cole. Long story, but neither one of us is schizophrenic.

    ReplyDelete
  20. Add on:

    There is, if Professor Cochrane is correct, a disconnect between Wall Street and American business.

    The DJIA fell from 10,880 to 9,488 on President Bush's watch.

    The DJIA rose from there to recently topping 17,000 on Obama's watch.

    I find it hard to reconcile steady investor optimism since 2009 with "lack of business confidence caused by Obama."

    BTW, I am a pro-business kind of guy. I do not like Obamacare, too complicated. I do like getting out of Iraqistan, and Obama has been far too slow at that. I prefer balanced federal budgets, and tell that to the GOP-dominated Congress and White of the Bush years. The Dems are hopeless too.

    Also, Bush got us into the $6 trillion mess Iraqistan, and Medicare Part D passed on his watch too. Medicare Part D places more liabilities onto taxpayers than the entire Social Security system (many Dems voted for Medicare Part D also).

    If American businesses are holding back on expansion and hiring as they lack confidence...egads. Investors sure do not lack confidence. The future looks good.

    What is lacking is aggregate demand. The Fed needs to be more pro-growth.
    Also, we should shrink the federal government.

    Speaking of burdens on taxpayers, what do you think will eat up more in the next 10 years, debt payments or defense spending?

    Well, debt payment are now running around $200 billion a year.

    Defense spending (DoD, VA, DHS, and black budget) about $1 trillion a year.

    In next 10 years, we will spend $10 trillion on defense, and $2 trillion on debt (a little less than a third of debt payments go back into the federal government, however, through publicly owned debt). Cochrane does points out we are vulnerable to rate hikes).

    Still, if one contends that federal debt is the housebuster, then what does one say about defense?




    ReplyDelete
    Replies
    1. Ben,

      "The DJIA fell from 10,880 to 9,488 on President Bush's watch.
      The DJIA rose from there to recently topping 17,000 on Obama's watch.
      I find it hard to reconcile steady investor optimism since 2009 with lack of business confidence caused by Obama."

      First you need to look at market capitalization (not the index level) to make some judgement on the level of investment. The index level could rise while the market capitalization falls (or vice versa).

      Second you are conflating the opinions of two groups (investors and business management). Investors do not make hiring / firing decisions for businesses.





      Delete
    2. Frank---
      Maybe so...still, when the Dow doubles in four years...and the latest employment report looked good...employers respond to demand.

      Delete
  21. "and that slow growth represents a self-inflicted wound"

    This is another place where historians and economists are likely to disagree. As Angus Maddison pointed out back in the 1980s, the period from 1945 was 1970 was unusual. High multipliers existed because large of large infrastructural projects in Europe and Japan (assisted with US and other aid ) through government capital expenditure led to large private capital expenditure, calling for infrastructural development for that new investment which led to further rounds of private capital investment.... This was sparked off by the one off recovery from massive destruction in Europe and Japan. (Most German and Japanese cities were literally flattened, along with something like 80 per cent of industrial production s). The US benefited from this due to its authority and power after winning the war - the US dollar anchored the international monetary and trading system, allowing it to have sustained payments deficits. Loans were to be repaid in US dollars - ending Sterling's role once and for all.

    After 1970 we approached the production frontier and productivity fell. You cannot expect the return to government expenditure we had back then.

    ReplyDelete

Comments are welcome. Keep it short, polite, and on topic.

Thanks to a few abusers I am now moderating comments. I welcome thoughtful disagreement. I will block comments with insulting or abusive language. I'm also blocking totally inane comments. Try to make some sense. I am much more likely to allow critical comments if you have the honesty and courage to use your real name.