Things to Read on the Morning of July 15, 2014

Should-Reads:

1. David F. Hendry and Grayham E. Mizon: Why standard macro models fail in crises: “Many central banks rely on dynamic stochastic general equilibrium models. The models’ mathematical basis fails when crises shift the underlying distributions of shocks. Specifically, the linchpin ‘law of iterated expectations’ fails, so economic analyses involving conditional expectations and inter-temporal derivations also fail. Like a fire station that automatically burns down whenever a big fire starts, DSGEs become unreliable when they are most needed…”

2. John Aziz: Rube Goldbergnomics, or how I learned to stop worrying and love fiscal stimulus: “It is strange, to say the least, to witness the logical machinations of those who believe that austerity is the answer to a depressed economy…. It is an inherently reactionary position.  That is it originates not so much as in being an idea designed to solve a problem, but an idea designed to justify a political position. More specifically, the political position that greater government is never the solution, and that government spending just sucks money out of the productive economy. And that, I think, is why so few austerians have updated their priors against austerity as a remedy to a depression, and continue to clutch at straws to justify their position…. Here’s the key thing: cutting government spending is contractionary by definition. Cutting spending is cutting spending. The net effect will not always be contractionary, of course, because sometimes it will lead to a confidence boost (particularly, I think, if the cut spending was particuarly wasteful). But that confidence boost… depends on a pretty nebulous mechanism: that businesses will see a government policy, interpret the policy in a certain way and choose to respond in a certain manner. It is a Rube Goldberg mechanism: action A needs to lead to action B, needs to lead to action C…. There is no guarantee that this stream of events will occur…. What isn’t Goldbergian? Boosting government spending is expansionary by definition…”

3. Emma Sandoe: Medicaid is the Best: Part 1: “Medicaid is my personal favorite federal (more accurately federal-state partnership, but you get what I mean) program.  If you read this blog regularly I will attempt to convince you of that fact and you too will love Medicaid.  Soon, we all will be on Team Medicaid and I will finally have a purpose for these hundreds of t-shirts I ordered. Today: Medicaid as an innovator…”

Should Be Aware of:

• Moses Finley: The Ancestral Constitution
• Justin Vaisse (2010): Why Neoconservatism Still Matters
• Barry Ritholtz: Pro Forecasters Stink, You’re Worse
• Robert Frost: North of Boston
• Claudio Borio (2012): The Financial Cycle and Macroeconomics: What Have We Learnt?
• Koleman Strumpf: The Effect of File-Sharing on Box-Office Revenue
• Ashutosh Jogalekar: Richard Feynman, sexism and changing perceptions of a scientific icon

And:

1. Robert Waldmann: Comment on Del Negro, Giannoni & Schorfheide (2014): “1) I have just skimmed the paper. I didn’t work through the equations. 2) I am very hostile to the whole discorso (roughly literature or research program). 3) I am more favorably impressed than I would like to be…. Del Negro et al contest the claim that some special nominal rigidity at zero change is needed to fit the data…. In effect the story of the 70s and 80s is one of the bold Volcker regime shift which caused a dramatic change in inflation by causing a dramatic change in expected future inflation. Here there are implications for variables other than inflation–in the 70s and 80s explicit forecasts of inflation from surveys, and in this millennium TIPS spreads as well. These implications are not tested…. Risk premia are central to Del Negro et als (and DeLong’s) explanation…. The paper does not confront the risk premia forecast by the model for 2008-2014 with the time series of actual risk premia…. I have an even crankier complaint about the financial frictions. They are modelled as the effect on risk premia of exogenous and otherwise unobserved variation in the variance in skill across entrepreneurs…. Since this variable appears only as a shifter in the risk premium… the microfoundations add nothing and subtract nothing…. The only implication of the microfounded model is that risk premia can vary for unexplained reasons and risk premia affect investment. My objection is that, since in practice all deviations between microfounded models and an ad hoc aggregate models are bugs not features, what possible use could there ever be in micro founding models?”

2. Hussein Ibish: What Israel and Hamas are really trying to accomplish in Gaza: “Hamas has been desperately trying to get out of this morass that it’s found itself in…. They tried to foment trouble in the West Bank, and it didn’t succeed. They didn’t get anything out of the unity agreement, so it’s falling back on what it knows sometimes gets results–which is rocket attacks. What they are hoping for, this time, is concessions not from Ramallah or from Tel Aviv, but from Cairo…. What Hamas can get can only come from Egypt. From Israel, they’re demanding the release of prisoners that were part of the shahid squad [a Hamas military group] that was arrested when Israel was pretending they didn’t know the teenagers were dead. Israel tracked them down and dealt Hamas a serious blow. Which is why Netanyahu isn’t so interested in getting into an artillery/aerial exchange with Hamas–the Israelis frontloaded their retribution. It was all done in the West Bank, before the bodies were found…”

3. Gregg Carlstrom: Is This Hamas’ Last War?: “Sisi’s military-backed [Egyptian] regime… has declared Hamas a terrorist organization, and destroyed most of the smuggling tunnels into Gaza on which the group relied for weapons and tax revenue. The tunnel closures have brought Hamas to a point of diplomatic and financial isolation, which compelled it to announce a reconciliation deal with Fatah in April…. Hamas agreed to a ‘national consensus’ government that contained no members of the group. The deal had already begun to flounder before the Israeli military campaign, with both sides arguing over who should control Gaza, and the kidnapping pushed the Hamas-Fatah relationship again to the point of collapse.”

Already-Noted Must-Reads:

1. Noah Smith: Should the Fed crash the economy now to prevent a crash later?: “To many, the implication is clear: The Fed needs to raise interest rates in order to prevent a destabilizing market crash. That isn’t a good idea…. Higher asset prices due to lower safe interest rates aren’t some kind of nefarious plot–this is just Finance 101…. That’s rational price appreciation, not a bubble…. When practically everyone is convinced that asset prices are relatively high, like now, it’s pretty obvious that there aren’t many greater fools out there. If you look at past bubbles, such as the late-’90s tech bubble or the mid-2000s housing bubble, you see that there was always a large contingent of society that thought it wasn’t a bubble at all…. Who nowadays thinks that there’s some special Big New Thing that’s going to push stocks and bonds and commodities all to stratospheric heights forever?…. I say we hold off on our calls for anti-bubble rate hikes.

2. Nick Rowe: Some simple arithmetic for mistakes with Taylor Rules: “If you see your neighbour thinking of doing something daft apparently unaware of one of the problems, you ought to speak up. Especially if it will affect you too, because you do a lot of trade with your neighbour. A fixed Taylor Rule… makes the danger of hitting the ZLB bigger than you think it is. And Taylor Rules don’t work at the ZLB…. What happens if you are wrong about the natural rate of interest, or wrong about potential output?… If actual potential output is one percentage higher than you think it is, that makes you set the nominal rate 0.5 percentage points too high, and so inflation would need to be 0.33 percentage points too low on average to have a big enough offsetting effect to cancel out your mistake…. For a normal central bank, that is a problem, but it is not a big problem…. They fix mistakes in their Taylor Rule as they go along…. That’s probably the main reason why we always observe a lagged interest rate in the equation when we estimate a central bank’s reaction function…. But if the parameter values of the Taylor Rule are fixed by law, central banks are not allowed to learn from their mistakes…. If you really really want to legislate a Taylor Rule, OK. But there’s a price you must pay, if you want to maintain the same margin of safety against hitting the ZLB. That price is a higher average rate of inflation built right into that legislated Taylor Rule. Your choice: legislated Taylor Rules; hitting the ZLB more frequently; a higher rate of inflation. Pick any two…”

3. Simon Wren-Lewis: Why macroeconomists, not bankers, should set interest rates: “[The] interest rate… which closes the output gap [maintains] the level of output and unemployment that will keep underlying inflation constant… [is] the Wicksellian natural rate…. But, respond[s]… the BIS… monetary policy cannot afford to ignore the financial sector, and the risk of excessive lending and bubbles…. The implication is that a financial crisis only happens because interest rates are set at the wrong level…. The… deregulation of the financial sector in the decades before?–not an issue. The widespread misselling of subprime mortgages?–these things happen. All the other examples of misselling and fraud?–boys will be boys. An industry that profits from a massive implicit public subsidy?–we see no subsidy. Classifying subprime products as AAA? Massive increases in bank leverage in the 00s?–all the result of keeping interest rates too low. When those putting the BIS case tell you that macroprudential controls (a.k.a. financial regulations) are ‘untested’ and ‘uncertain in their impact’, what they are really saying is that the financial system cannot be regulated to make it safe when interest rates are low….
    
   “I like to praise the current UK government when I can. In setting up a Financial Policy Committee that is separate from the Monetary Policy Committee they did exactly the right thing. This formalises an assignment: macro prudential policy to control financial sector excess, and interest rates to control demand and inflation. Most macroeconomists know this makes sense. But the financial sector has a pecuniary interest in pretending otherwise. Those that get too close to that sector should be kept well away from setting interest rates.”