Month: December 2013

Paul Krugman: Microfoundations and the Parting of the Waters:

Phelps… [made] two observations… nominal shocks had large real effects… [and] with everyone acting rationally, money should have been neutral even in the short run. Traditional Keynesian analyses… [only provided] ex-post rationalizations…. So the Phelps crowd came up with a lovely story…. Individuals and firms couldn’t tell… whether a rise in the price… represented a shock specific to them… or a general change in demand… confusion could explain why short-run aggregate supply seemed upward-sloping…. This meant that the apparent tradeoff between unemployment and inflation would be unstable…. The stagflation of the 70s seemed to confirm this prediction, and brought the microfoundations project immense prestige…. Freshwater economists gleefully proclaimed Keynes dead, the subject of nothing but ‘giggles and whispers’.

But… Phelps-Lucas/type microfoundations quickly collapsed both intellectually and empirically. Intellectually… rational individuals simply should not have been confused in [that] way…. Empirically… slumps last too long…. Microfoundations in macroeconomics… failed utterly at the one thing it was sold, above all, as being able to do…. Time, you might think, to reconsider…. But many… had so committed themselves to the idea that Keynes was dead and rationality roolz that they simply dug in deeper….

Now we have people debating whether models with microfoundations lead to better predictions… [even though] the microfoundations are wrong…. But what you want to realize is that this isn’t going to convince the microfoundations crowd. After all, more than thirty years ago they decided that the joy of microfoundations trumped the utter failure of microfounded models to work… and… have now trained successive cohorts of students in this view. There are, it’s true, some hints of a guilty conscience… the odd tendency of freshwater types to immediately accuse anyone with saltwater ideas of being dishonest. (I’m not a nice guy, but if look at what I said about, say, Cochrane, it was that he was ignorant, not corrupt.)…

The notion that there had been a convergence of views by 2007, which was then ruptured by the crisis, was a saltwater delusion. People like Olivier Blanchard convinced themselves that the other side was listening; it wasn’t. The hysterical reaction to the notion that fiscal policy is effective at the zero lower bound demonstrated that the freshwater types had never bothered to learn…

Continue reading “Morning Must-Read: Paul Krugman’s Take on the History of Macroeconomic Thought” →

Robert Solow: Alan Greenspan Is Still Trying to Justify His Bad Decisions: What the maestro doesn’t understand:

When the stock market collapsed by almost a third one day in October 1987, the Fed… stood ready to provide every bit of the liquidity that might be needed to keep the financial system functioning, so that anyone who acted in panic would probably live to regret it…. Score one for Greenspan. During the long Clinton-era upswing from 1992 to 2000, Greenspan and the Fed faced a much more complex problem, and again did the right thing. Nearly all… believed that the key inflation-safe unemployment rate… was something like 6.5–7.0 percent. As the upswing continued and the unemployment rate drifted down below that level (and, you may remember, budget surpluses appeared), the Fed was beset with urgent reminders that the time had come, and maybe passed, to tighten credit…. Greenspan looked at the data… and persuaded his colleagues to let the expansion go on. In the end the unemployment rate dipped briefly below 4.0 percent without trauma. Greenspan thought that productivity was improving faster than anyone or the conventional measurements realized, and that was what provided the room for further expansion. He was right…. It was an exhibition of pragmatism and cool that saved the economy from wasting trillions of dollars of output in unnecessary unemployment and idle capacity. There ends the plus side of the Greenspan ledger.

Continue reading “Robert Solow Reviews Alan Greenspan’s ‘The Map and the Territory’” →

Paul Krugman attributes the healthier state of international macroeconomics (i.e. him, Ken Rogoff, and company) than non-international macroeconomics (i.e. Ed Prescott, Robert Lucas, and company) to (a) the fact that reality in international macro had more of a Keynesian bias, and (b) the influence of Rudi Dornbusch. I actually think Paul understates the contribution of Rudi Dornbusch…

Paul’s point is that the Post-Modern Chicago-Minnesota New-Classial “monetary policy doesn’t matter” view was obviously and ridiculously inadequate in international macroeconomics because there was a very important real price–the real exchange rate–that clearly jumped far and fast in response to changes in monetary policy. Thus it was prima facie ludicrous to claim that monetary policy did not have important real effects.

But non-international macroeconomics also has an important real price that clearly jumps far and fast in response to changes in monetary policy: the real value of the stock market–monetary policy affects the terms on which old capital trades for consumption goods. Thus it was similarly prima facie ludicrous to claim that monetary policy did not have important, systematic, and persistent real effects. But that did not stop them…

Continue reading “Yet Another Note on Understanding the Terrain of the Macroeconomics Debate” →

…that all of you seeking to provide proper Cass Sunstein “nudges” to sleepy members of your family making oatmeal in the morning not put the ground habenero chiles next to the cinnamon in the spice rack?

One way to think about things is that there are three important macroeconomically-relevant prices in financial markets. (1) There is the liquidity discount: how much you have to pay in order to hold your investible wealth in a form in which you can spend rather them in the form in which it grows. (2) There is the slope of the intertemporal price system: the real interest rate at which safe invested wealth grows. (3) And there is the risk premium: how much extra you get on average for being willing to bear the risks of enterprise and battle the forces of time and ignorance.

Conventional monetary policy tools focus on the first. But in so doing, they may create distortions in the second as they try to correct problems with the first. And what if the root cause of financial distress is the third: the combination of a collapse in the investor willingness to hold risky assets coupled with a collapse in the financial intermediaries ability to credibly promise to create safe assets?

It is in those situations that nonstandard monetary policy tools–interest on reserves, quantitative easing, and other things–come into their own. But what do they do? How do they work? Do they work?

Let me turn the microphone over to one of the smartest and most thoughtful analysts today, Joe Gagnon:

Continue reading “Joe Gagnon Responds to Michael Woodford, Ben Bernanke, and Others on the Risks and Power of Quantitative Easing: Friday Focus (December 20, 2013)” →

Must-Reads:

1. Lane Kenworthy: America’s social democratic future: “The controversy surrounding the ACA shows no sign of ending…. The ACA represents another step on a long, slow, but steady journey away from the classical liberal capitalist state and toward a peculiarly American version of social democracy…. Powerful forces will continue to fight.. the resulting social insurance policies will emerge more gradually and be less universal, less efficient, and less effective…. But the opponents are fighting a losing battle and can only slow down and distort the final outcome…. Thanks to a combination of popular demand, technocratic supply, and gradually increasing national wealth, social democracy is the future of the United States.”

2. Nick Rowe: Worthwhile Canadian Initiative: Microfoundations we like vs microfoundations we can solve: “Take just one example… Calvo pricing…. Make one very small change…. Assume she visits… each firm once every n periods…. That’s a different model… a nightmare to solve. Both those models are equally microfounded. Or equally not microfounded, because the fairy herself is, well, just… an ad hoc fairy… a metaphor for our ignorance about why the price of money (the reciprocal of the price level) doesn’t behave like the prices of other financial assets…. The non-random fairy generates inflation-inertia and the random fairy doesn’t. You get a sticky inflation rate, and not just a sticky price level, with the non-random fairy…. I can solve the first model, but I can’t solve the second model…. I have three options… assume microfoundations I don’t like… assume microfoundations I like… and wave my hands… write down an equation for an ad hoc Phillips Curve with inflation inertia, wave my hands…”

3. Even from Maui, Mark Thoma * continues to direct me to very interesting things–in this case: *Simon Wren Lewis: More on the illusion of superiority: “An ad hoc but data-inspired modification to a microfounded model (what I call an eclectic model) can produce a better model than a fully microfounded model…. A misspecified model can produce bad policy. These misspecification errors may far outweigh any errors due to the Lucas critique…. Tony’s position is that policymakers in a hurry can do this eclectic stuff, but we academics should just focus on building better microfoundations…. First, building better microfoundations can take a very long time. Second, there is a great deal that academics can say using… useful models…. Go back to the 1970s…. [If] policymakers in the 1970s… wanted to devalue their currency because they felt it had become overvalued after a temporary burst of domestic inflation… microfounded models would have said there was no point…. Those using eclectic models with ad hoc price rigidities would have known better…. Should academic macroeconomists in the 1970s have left these policymakers to their own devices?…”

4. Dean Baker: Assessing Neil Irwin’s Assessment of Ben Bernanke: “Irwin… downplays… [how] Bernanke failed to appreciate the disaster… as it was unfolding…. failed to recognize that the loss of more than $1 trillion in annual demand from the collapse of the housing bubble could not be easily replaced… missed the depth of the financial crisis. For example, after Bear Stearns collapsed in March of 2008, he testified to Congress that he didn’t see another Bear Stearns out there. Of course there were plenty more Bear Stearns out there with names like Lehman, AIG, Fannie Mae, Freddie Mac, Goldman Sachs etc. The whole gang would have gone belly up by the end of the year were it not for massive intervention by the government…. The claim that Bernanke could not have rescued Lehman because they lacked the legal authority is also dubious. Bernanke did many things in the crisis with questionable legal authority. Suppose that the Fed and Treasury had rescued Lehman, who would have taken them to court? This one might fool little kids and Washington Post reporters, it is not the sort of thing that adults need to take seriously.”

Continue reading “Things to Read on the Morning of December 19, 2013” →

Lane Kenworthy: America’s social democratic future:

Since March 2010… the Affordable Care Act… has been at the center of American politics. Tea Party activists and their allies in the Republican Party have tried to stymie the law at nearly every turn. The Republican-controlled House of Representatives has voted more than 40 times in favor of repealing or defunding it, and last October the House allowed a partial shutdown of the federal government in an attempt to block or delay the law. The controversy surrounding the ACA shows no sign of ending anytime soon…. The ACA represents another step on a long, slow, but steady journey away from the classical liberal capitalist state and toward a peculiarly American version of social democracy…. Powerful forces will continue to fight those efforts, and the resulting social insurance policies will emerge more gradually and be less universal, less efficient, and less effective than they would otherwise have been. But the opponents are fighting a losing battle and can only slow down and distort the final outcome rather than stop it. Thanks to a combination of popular demand, technocratic supply, and gradually increasing national wealth, social democracy is the future of the United States.

Even from Maui, Mark Thoma * continues to direct me to very interesting things–in this case: *Simon Wren Lewis: More on the illusion of superiority:

An ad hoc but data-inspired modification to a microfounded model (what I call an eclectic model) can produce a better model than a fully microfounded model…. But what about the Lucas critique? Surely that says that only a microfounded model can avoid the Lucas critique…. A misspecified model can produce bad policy. These misspecification errors may far outweigh any errors due to the Lucas critique…. Tony’s position is that policymakers in a hurry can do this eclectic stuff, but we academics should just focus on building better microfoundations…. First, building better microfoundations can take a very long time. Second, there is a great deal that academics can say using eclectic, or useful, models…. Go back to the 1970s…. Microfoundations modellers… said price rigidity should not be in macromodels because it was not microfounded…. [If] policymakers in the 1970s… wanted to devalue their currency because they felt it had become overvalued after a temporary burst of domestic inflation… microfounded models would have said there was no point…. Those using eclectic models with ad hoc price rigidities would have known better…. Should academic macroeconomists in the 1970s have left these policymakers to their own devices?… The idea that the only proper way to do macro that involves theory is to work with fully microfounded DSGE models is simply wrong…. If our DSGE models were pretty good descriptions of the world then this misconception might not matter too much, but the real world keeps reminding us that they are not.”

Let me endorse this:

Ryan Avent: Monetary policy: Sneaky stimulus:

I wrote that the Fed was unlikely to taper because inflation is so low; the choice to go ahead and taper anyway certainly looks like evidence that they’re not that worried about prices. But it has also been clear that the Fed is trying to rely more heavily on forward guidance so as to free themselves from the need to continue with QE. And guidance about inflation changed yesterday in what looks to me like a subtle but important way. The first change comes at the top of the statement, where in October the FOMC said:

The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, but it anticipates that inflation will move back toward its objective over the medium term.

Yesterday this became:

The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that inflation will move back toward its objective over the medium term.

Continue reading “The Federal Reserve Puzzles Ryan Avent” →