Category: Equitablog

J. Bradford DeLong :: U.C. Berkeley and NBER :: delong@econ.berkeley.edu

For BPEA Spring 2015 8:30 AM March 20, 2015

Let me thank Matt for doing some very serious and thoughtful digging. The upshot is that I am in an ideal position for a discussant: There are very interesting and important numbers that have not been put together before, and there is an author who is wise enough not to believe he has with the numbers mean nailed.

Thus I am in an excellent position to, if not add intellectual value, share lavishly in intellectual rents.

I was weaned on the explanation of recent trends in US inequality set out by the very sharp Claudia Goldin, Larry Katz, and company. It was skilled-biased technical change, coupled with the end of the era that had begun in 1636 of making increasing educational levels a priority. That combination greatly raised the return to education-based skills. That was the principal driver of rising income inequality.

But, recently, reality does not seem to agree.

To get large swings in the income distribution out of small changes in the relative supply of educated workers seems to require less substitutability between formal college and other factors of production then seemed reasonable. Higher experience-skill premiums and sharply higher education-skill premiums, yes. But the action seems to be far, far out in the upper tail.

A little family history: My Grandfather Bill was in not just the 1% or the 0.1% but the 0.01% back in the days before the rise in inequality. He sold his chemical construction company to the IMF conglomerate and retired back in 1968.

One of his other grandsons, my first cousin Phil Lord, might have a chance of making it into the same financial range–if he can make the transition from co-director to “producer” and “created by” credits–but if he does he will still be breathing much less rarified relative air.

Relative to 1968 you need 3.5 times the wealth now in the U.S. and 8 times the wealth worldwide. That is an income and wealth an order of magnitude higher than my grandfather ever did.

It is simply not possible to see such an extreme concentration of benefits as in any way a return to a factor of production obtained as the product of “hours spent studying” times “brainpower”.

Thomas Piketty has a guess.

He guesses that the real explanation is that 1914-1980 is the anomaly. Without great political disturbances, wealth accumulates, concentrates, and dominates.

What about what John Maynard Keynes called the “euthanasia of the rentier”? As accumulation proceeds the relative fall in the rate of profit exceeding the relative rise in concentrated wealth? Piketty points to remarkable constancy in the rate of profit at between 4% and 5% per year, but is agnostic as to whether the cause is easy capital-labor substitution, rent-seeking by the rich, or social structure that sets that as the “fair” rate of profit.

And this is why it is truly excellent that Matt Rognlie brings well-ordered and insightfully-organized data to these questions.

Matt’s focus on the net capital share is surely right.

I never understood why, in the Solow model, gross savings was supposed to be a function of gross output anyway. There are the big worries over the data.1 Let me skip those.

As Matt stressed, the big news in the post-World War II net capital share is the surge in housing: from 3% to 8% of private domestic value added.

How much of this is a real increase in housing intensity? How much reflects congestion driven by exhaustion of the low-hanging superhighways? How much is rent-extraction via NIMBYism? How much trust do we give to these “imputed rent” imputations anyway?

And what hat does this mean, anyway?

There has always been a problem with using our GDP estimates as social accounts. In GDP, we measure each unit’s contribution to production at the final unit’s marginal cost and each unit’s contribution to societal well-being at the final unit’s money-metric marginal utility. In the presence of anything like near-satiation in consumption, or of near-exhaustion in productive capacity, this does not convey a true picture.

Hard questions. No very good answers.

The fact that the big news since World War II is a rise in housing as a share of value added raises the question of whether this surge may be in significant part the reversal of story from a century ago–now the rise of valuable urban housing, then the decline of valuable Western European rural farmland.2

To the extent that land is the driver of shifts in our capital share, this is clear a problem to the extent that it is driven by NIMBYism. But is it a problem otherwise?

And as Matt also stressed, the secondary big news in his numbers is the pre-1990 fall in the net capital share, a fall driven by a very real rise in depreciation is real. Our capital stock has seen the replacement of long-lasting machines to perform Wellman-Lord desulfurization reactions with video editing machines rapidly obsoleted by Moore’s Law.

But it is puzzling that the pre-1990 fall in the net capital share not matched by a decline in the relative capitalization of the corporate sector. Matt points out a steady rise in capitalization up to the late 1960s, followed in the 1970s by a “negative bubble”–truly absurdly high earnings yields on equities–that lasts well into the 1980s. Then we see a bubbly rise in the relative capitalization of the corporate sector since the start of the 1990s–a rise that persists in spite of sub-par business-cycle performance. Very puzzling.

Let me end by strongly endorsing what I take to be Matt Rognlie’s bottom line. I take it to be that post-WWII variation in the observed net capital share is not explainable

via returns on the underlying assets. Instead, the decomposition in section 3 attributes most of the variation to pure profits, or markups…

Accumulation and returns play, outside of housing, a distinctly secondary role, if they play any role at all. But it is equally hard to find any role for the race between education and technology, and there should be if we think the factors of production are labor, education skills, and machines.

Likewise, variation in income inequality, is hard to attribute to wealth ownership or to human capital investment or to differential shifts in rewards to factors like raw labor, experience-skills, education-skills, and machines. Matt thus concludes that:

Concern about inequality should be shifted away from the split between capital and labor, and toward other aspects of distribution, such as the within-labor distribution of income.

The nly caveat I wish to make is: This is true now. This may not be true in 50 years, if Piketty is right

And Matt’s conclusion is bad news for us economists, for it leaves us in the same position as those trying to explain an earlier large puzzle in the production function, the twentieth-century retardation of the British economy.

It was Robert Solow who said:

Every discussion among economists of the relatively slow growth of the British economy compared with the Continental economies ends up in a blaze of amateur sociology…

I really would like for us to be able to do better.

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Notes:

[1] These big worries are:

• Worries about depreciation allowances in these accounts. Mine are perhaps bigger than most.

• Worries about how much of the value that comes from installing capital comes from (local) learning about how to handle the technology, and is something that does not depreciate from the point of view of the individual firm. That is not captured.

• Worries about, from the societal point of view, how much of the value that comes from installing capital comes from global learning about how to handle the technology.

• Perennial worries about what in high-end labor incomes are really incomes earned by raw labor and human capital, and what are rent-extraction and thus sharing in the returns to capital.

[2] In America things are different: the frontier. But in Western Europe one thing going on at the end of the Belle Époque is the collapse in the value of rents on absentee-owned European farmland.

Downton Abbey–Highclear–was supportable on its entailed rents a generation before World War I. It was not so afterwards. Some of this was taxes. But there was also a steep relative fall in prices of staple foodstuffs. Not just Iowa and Kansas, but Odessa and New Zealand came online.

Western European farmland lost its value as a factor of production at the end of the nineteenth century. To what extent was that it? And to what extent is “it now the rise of housing prices in London, Paris, Rome, Milan, etc.? My teacher the late David Landes, a CUNY graduate, simply bought a Paris apartment as a postdoc post-WWII. Those of our postdocs who could not afford to go to private colleges do not pick up Paris apartments casually in the course of a research trip to take a look at bank records.

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1509 words

Must- and Shall-Reads:

• Today’s Must-Must-Read: Lars E.O. Svennson: “Riksbank Deputy Governor Jansson Again Tries to Defend the Indefensible,
• Nighttime Must-Read: Grégory Claeys et al.: European Central Bank Quantitative Easing: The Detailed Manual
• Today’s Must-Must-Read: Matt O’Brien: What People Talk About When They Talk About Zero Interest Rates
• Peter Gosselin and Jennifer Oldham: If Economists Were Right, You Would Have a Raise by Now
• Paul Krugman: “The way to deal with secular stagnation… is to raise the long-run neutral interest rate above zero. If we can do this via structural reform and/or self-financing infrastructure investment, fine. If not, raise the inflation target…. If you’re really worried about secular stagnation, you should advocate a combination of a raised inflation target and a burst of fiscal stimulus to help the central bank get there…”
• Afternoon Must-Read: Jared Bernstein: The U.K. vs. the U.S. Minimum-Wage Debate
• Matthew Zeitlin: Blog Fight! War Of Words Breaks Out In A Multi-Trillion Dollar Industry
• Afternoon Must-Read: Helaine Olen: Poor Stories from [David] Brooks and [Ross] Douthat
• Tim Duy: The End of “Patient” and Questions for Yellen
• Nighttime Must-Read: Nick Bunker: One Slack Measure to Rule Them All?
• Nighttime Must-Read: Simon Wren-Lewis: Eurozone Fiscal Policy
• Lunchtime Must-Read: Paul Krugman**: A Whiff of Stagflation

Should Be Aware of:

• Michael McAuliff: “When aliens didn’t arrive in spaceships to save Keech and her followers on Dec. 21, 1954, as she predicted, it did not, at least as far as Keech’s followers were concerned, reveal her as a fraud…. When Congress debated and passed the Patient Protection and Affordable Care Act in 2009 and 2010, opponents were nearly unified in offering grim Keech-like predictions…. The dour prognostications are starting to look like Keech’s flying saucers…. [But] that won’t matter, and… Americans can expect a continued drumbeat of doom, even as the prophecies fail…”
• Glenn Fleishman: I, for One, Welcome Our New Newsletter and Podcast Overlords
• Mark Zandi: U.S. Macro Outlook: A Long Expansion
• Michael Wolf: Gigaom: The Life and Death of a Venture-Funded Media Startup

Today’s Must-Must-Read: Lars E.O. Svennson: “Riksbank Deputy Governor Jansson Again Tries to Defend the Indefensible, the Riksbank’s sharp tightening of monetary policy in the summer of 2010…from 0.25 percent to 2 percent…

…There were really, in real time, no comments suggesting that it would be a stupid idea to increase the interest rate.

But in real time, the Riksbank’s inflation forecast was below the inflation target and unemployment and the unemployment forecast were far above the Riksbank’s estimate of a long-run sustainable rate…. My colleague in the Execeutive Board, Karolina Ekholm, and I indeed dissented from this tightening policy with very clear and logical arguments, namely that easier policy would in this situation lead to better target achievement…. Riksbank and the Fed FOMC forecasts for inflation and unemployment were very similar at the time. Given these similar forecasts, the Fed obviously did the right thing, keeping the policy rate very low and starting to prepare for QE2, whereas the Riksbank did the wrong thing, tightening. Or is Jansson suggesting that the Fed should have followed the Riksbank example?
 
Jansson refers to high GDP growth as a reason for tightening in the summer of 2010. But as Paul Krugman says… Jansson seems to make “a fundamental error, confusing levels with rates of change.”… Jansson… suggests that Krugman should look at the facts before criticizing the Riksbank. It seems that it is Jansson that should look at the facts. Jansson’s previous attempts to defend Riksbank policy, including his strange suggestion that the tightening was not motived by concerns about household debt and housing prices, have been discussed here, here, and here. The cost and benefit of the Riksbank’s leaning against the wind because of concerns about household debt are examined here (with the use of the Riksbank’s own estimates, the cost can be shown to be about 250 times the benefit).

The continued refusal by policymakers in 2008-2012 to admit any error whatsoever is what seems to me the most remarkable feature of the situation. It’s not just Jansson. Consider Tim Geithner, for example: the paragraphs in his book expressing regrets about policy choices were, when he was asked about them on his book tour, taken as opportunities to try to walk back the regrets–for, Geithner said at some length, the alternative policies really would not have done any good. The only first-rank policymaker I have seen in person clearly and visibly regret his overoptimism and his failure to grasp the reality of the situation was Ben Bernanke.

Karl Whelan sends me to Grégory Claeys et al.: European Central Bank Quantitative Easing: The Detailed Manual: “The… Public Sector Purchase Programme (PSPP), started on 9 March 2015 and will last at least until September 2016…

…Purchases will be composed of sovereign bonds and securities from European institutions and national agencies. The ECB Governing Council imposed limits to ensure that the Eurosystem will not breach the prohibition on monetary financing. However, these limits will constrain the size and duration of the programme…. The PSPP profits that will ultimately be repatriated to national treasuries will be small. This was to be expected, given current very low yields…

Today’s Must-Must-Read: This is an important point that is worth saying as often as necessary–perhaps as often as possible:

Matt O’Brien: What People Talk About When They Talk About Zero Interest Rates: “There’s something about zero interest rates that makes people go a little crazy…

…At least that’s what Wall Street thinks. Gillian Tett… tell[s] us… they think in between their flights from Davos to Aspen… that:

ultra-low interest rates have a nasty habit of distorting markets in all manner of unexpected ways, all over the world… [in the money in] U.S. activist funds, angel investments, laying down wine or jumping into the art market.

In other words, we should worry that billionaires are paying so much for Picassos and pinot noirs as part of the hyperinflation in the Hamptons. Now it’s true that lower interest rates make asset prices go up, but ‘distorts’ is a funny way of putting that. After all, we don’t say that higher interest rates ‘distort’ asset prices down…. [If] rates are inappropriately low… where’s the inflation? It’s not like central banks can keep rates lower than they should without prices going higher….

It’s the economy, not interest rates, that are distorted. People want to save more than they want to invest, and that is why rates are so low…. The mistake that Wall Street, and even some famous economists, make is… they think that lower rates are what’s messing up the economy, rather than reflecting the fact that it’s already messed up….

Just look at the countries that have tried, and failed, to keep rates up after they’ve hit zero: Japan, Europe, and Sweden. Each of them told themselves a story about why they needed to hike rates—they thought they’d recovered, or inflation was coming to get them, or maybe a bubble–and they each did so…. Well, it turns out that raising rates when your economy is still kind of weak isn’t a good idea. All of them ended up having to cut rates back down to zero, and then start buying bonds with newly-printed money…. It’s not the Fed’s job to worry about the Billionaire Price Index. It’d be… unnatural if it did.

The neutral or natural rate of interest is the rate of interest that balances desired savings with planned investment when the economy is at full employment, and when people’s expectations of the prices and inflation rates which they will be able to charge or have to pay are by-and-large correct. That is how things have been ever since Knut Wicksell started this particular sub literature of economics back in 1898. As John Maynard Keynes wrote back in 1923, having the market interest rate below or above the natural interest rate corresponds to monetary policy that produces a money stock that is either inappropriately high or inappropriately low, and generates:

inflation [which] is unjust and deflation [which] is inexpedient. Of the two perhaps deflation is, if we rule out exaggerated inflations such as that of Germany, the worse; because it is worse, in an impoverished world, to provoke unemployment than to disappoint the rentier. But it is necessary that we should weigh one evil against the other. It is easier to agree that both are evils to be shunned…

The right way to think about it is: Yes, interest rates are scarily low right now. But they are so because the Federal Reserve and other central banks are trying to mitigate the damage caused by the fact that the entire global macroeconomy is so distorted–inappropriate fiscal austerity, a global savings glut coming from emerging markets and elsewhere, secular stagnation, and a clogged housing-finance channel.

Jared Bernstein: The U.K. vs. the U.S. Minimum-Wage Debate: “Salient differences between the U.K. minimum-wage debate and our own, where non-credible critics continue to hold forth and command considerable influence…

…in blocking an increase in the minimum, at least at a national level. House Speaker John A. Boehner (R-Ohio) consistently rails against the policy as a ‘job killer.’ There’s even a whole ‘think tank,’ backed by the fast-food lobby, that exists to oppose minimum-wage increases and refute research like that of Manning…. What is it about our economic debates that often insulates them from facts? Why do views that are known to be wrong or overblown–it’s not that the minimum wage never costs anyone a job, but that the beneficiaries far outweigh the losers–continue to get an equal hearing?… Media outlets and journalists whose job it is to report on these issues do not want to be labeled as biased…. You can blame the news media for this…. But many others don’t have the time or the firepower to figure out who’s right. Money interacts in important ways here, more so here than in the United Kingdom and other advanced economies…. U.K. policymakers have of course shown themselves capable of making bad economic moves based more on ideology than fact…. But at least regarding the minimum wage, policy there has in no small part been driven by facts, compromise, collaboration and acknowledgement that in the face of those facts, a formerly held position was wrong. Why, oh why, does that sound so incredibly out of reach in today’s American politics?

Helaine Olen: Poor Stories from [David] Brooks and [Ross] Douthat: “A Tree Grows in Brooklyn is… more akin to Dickens than the world imagined by Douthat and Brooks…

…and certainly not one you’d like to think is based on a true story…. An alcoholic father… a mother way too overwhelmed… to show much love to her children. A pervert… attempts a sexual assault on the prepubescent Francie…. The Nolan family savings account… is constantly being raided. Francie’s Aunt Evy’s husband abandons his family. Another aunt ‘gets around’…. Her parents… fake an address in a better neighborhood… forced to drop out of school when her father dies and her mother is unable to support her family…. [A] memoir by Laura Ingalls Wilder… features wife beaters and murderers… Pa skipping out of town without paying the rent. Publishers of the 1930s passed on Wilder’s true-life tale, only responding when she and her daughter Rose Wilder Lane (who complained in her diary of growing up with ‘no affection, poverty, inferiority’) turned the rejected manuscript into the more homespun Little House in the Big Woods…. Even at the time, few readers wanted to hear the truth. Just as our own age does, the late 19th and early 20th century attracted a goodly share of two-bit moralists who confused cause and effect when it came to the lives of the lower classes…. When the young Francie Nolan writes about the truth of her life in A Tree Grows in Brooklyn, the response from her teacher is less than sympathetic: ‘Drunkards belong in jail not in stories. And poverty. There’s no excuse for that. There’s work enough for all who want it. People are poor because they’re too lazy to work. There’s nothing beautiful about laziness.’… This world receded, not because post-war Americans suddenly acquired morals, but because they achieved prosperity, not to mention a social safety net…. The second Gilded Age is imitating the first. None of this history features in the columns of Brooks, Douthat or others like them, however, who all warble on about an imaginary past.

Apropos of my too-hot-for-Equitable-Growth, Time for a Rant!: Why Oh Why Cannot We Have Better Economists?, Paul Krugman inquires asks whether:

have forgotten, or perhaps never noticed, was Levine’s rant against me back in 2009, accusing me of failing to understand the depth and power of modern economic analysis.

I cannot remember reading it. It is a doozy–I will put it way down at the bottom. I will cut off the list of errors and just note the first four things I found wrong with it:

1. “Who are these economists who got it so wrong? Speak for yourself kemo sabe. And since you got it wrong…”: Actually, Paul Krugman got it much more right than David K. Levine–April 18, 2005 sees Paul warning that the housing bubble (excuse me, DKL would say “elevated housing prices because rational expectations failed to evaluate what turned out ex post to be risks”) might collapse (excuse me, DKL would say “rationally-expected fundamentals might be rapidly revised downward”) with dire macroeconomic consequences.
2. “Here we are, the recession is over and we’ve spent 10% of the money…. Not the 200% you thought we needed to end the recession…”: It is unclear whether DKL knows and is misleading his readers or is ignorant here: the 200%-of-stimulus was the amount thought likely not to half the decline in output but to return the economy to full employment.
3. “John Cochrane has tried to educate you about what we’ve learned about fiscal stimulae…”: “Stimulus” is a second-declension Latin noun: its nominative plural is “stimuli”; its dative-ablative plural is “stimulis”. You could argue for either in this English sentence. You cannot make a case for “stimulae”.
4. “You haven’t followed the debate about the causes of depressions between Peter Temin on one side and Timothy Kehoe and Ed Prescott on the other?…”: To the contrary, I know for a fact that Paul Krugman followed the Temin vs. Kehoe-Prescott debate rather closely.

Oops. It turns out I cannot cut (9):

(9) “I feel a little like a physicist at the cocktail party being assured that everything is relative. That isn’t what the theory of relativity says: it says that velocity is relative. Acceleration is most definitely not…”: Acceleration is not relative in Special Relativity. The central insight underlying General Relativity–the whole point of the Principle of Equivalence–is that acceleration, too, is relative: that there is no difference between being in a gravitational field and being in an accelerating frame of reference. That’s why it is called General Relativity!

We mock and snark here–Paul writes:

We need a name for a syndrome related to, but not quite the same as, the Dunning-Kruger effect… involv[ing] not competence but knowledge. The truly ignorant, I often find, don’t know that they’re ignorant–in fact, they’re often under the delusion of having deep knowledge and understanding…

But there is a very serious issue here. Back in 2009-2010 the austerians told us that expansive monetary policies–especially QE–were supposed to risk outbursts of stubborn and persistent inflation, in spite of the fact that financial markets were forecasting no such thing. The austerians told us that not fiscal expansion but fiscal austerity would speed the recovery from the Lesser Depression by restoring confidence. History since 2009 has not been friendly to either of these confident predictions.

Yet if there is a single prominent economist who made these predictions back in 2009 and 2010 who has undertaken any rethinking–done anything to even try to mark their beliefs to market–their doing so has escaped me.

I am happy to say what I have gotten wrong since 2005:

• Believing that central banks would make stabilizing the path of nominal GDP around its previous long-term trend their first and overwhelming priority, and would not rest until they had done so.
• Believing that all parties in governments would support them, understanding that a strong economy is the easiest road to reelection, that prosperity is a virtue, and that structural adjustment is much easier to accomplish in a high-pressure than in a low-pressure economy.
• Believing that governments understood both parts of the Bagehot Rule–that you lend freely at a penalty rate, which means that if you are propping up institutions of doubtful solvency you take their equity. (Yet you weren’t listening were you, Mr. Geithner, Mr. Obama?)
• Believing that governments understood that it was important to get whatever our new framework of housing finance is operational quickly so that the single-family housing credit channel would no longer be blocked. (Yet you weren’t listening were you, Mr. DeMarco, Mr. Watt, Mr. Geithner, Mr. Lew, Mr. Obama?)
• Believing that we were very unlikely to find ourselves in a situation in which monetary policy would have little expansionary traction.

Revising my beliefs about how the world works in the wake of those five major ex post analytical mistakes has been an important part of what I have been and am trying to do. But when I look around at the economists who forecast inflation and the benefits of expansionary fiscal austerity, I find myself rather… lonely…

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Reference:

David K. Levine: An Open Letter to Paul Krugman: “I was reading your article How Did Economists Get It So Wrong…

…Who are these economists who got it so wrong? Speak for yourself kemo sabe. And since you got it wrong – why should we believe your
discredited theories?

It is a sad fact that whenever something bad happens people will claim that it means that they were right all along, and other people will listen to them. A professional prosecutor frustrated by the fact that you can’t beat confessions out of suspects? Wait until September 11 and try again and this time call it the “Patriot Act.” A progressive who would like to see higher taxes and more government programs? Wait until there is an economic crisis and call it a “fiscal stimulus bill.” Here we are, the recession is over and we’ve spent 10% of the money…. Not the 200% you thought we needed to end the recession.

It is a daunting task to bring you up to date on the developments in economics in the last quarter century. I know that John Cochrane has tried to educate you about what we’ve learned about fiscal stimulae in that period. But perhaps I can highlight a few other
developments? You seem under the impression that economists had resolved their internal disputes before the financial crisis. So that means you haven’t followed the debate about the causes of depressions between Peter Temin on one side and Timothy Kehoe and Ed Prescott on the other?

You say that we think that the “central problem of depression-prevention has been solved.” Has it not? Are you forecasting that this recession will turn in to a depression? But of course “More important was the profession’s blindness to the very possibility of catastrophic failures in a market economy.” That would be the profession that hasn’t been reading what the profession has written? Perhaps you should go look at that controversial book Kehoe and Prescott [2007], Great Depressions of the 20th Century. Or you might read Sargent, Williams and Zhao [September 2008], “Conquest of Latin American Inflation”. Wouldn’t it be nice if people had some idea of what was being written before criticizing it? 

Let us talk more seriously about the supposed failure of the economics profession. You say “Few economists saw our current crisis coming, but this predictive failure was the least of the field’s problems.” The predictive failure is not a problem of the field – it is a problem for those who are under the impression that we should be able to predict crises. Do you number yourself in this bunch? Do physicists get it wrong because their theory says that they cannot predict where a photon shot through a sufficiently narrow slit will land? Economic models are like models of photons going through slits. Just as those models predict only the statistical distribution of photons, so our models only predict the likelihood of downturns–they do not predict when any particular downturn will occur. Saying “most economists failed to predict the downturn” is exactly like saying most physicists failed to predict the impact of the twelfth photon passing through the slit.

More to the point: our models don’t just fail to predict the timing of financial crises–they say that we cannot. Do you believe that it could be widely believed that the stock market will drop by 10% next week? If I believed that I’d sell like mad, and I expect that you would as well. Of course as we all sold and the price dropped, everyone else would ask around and when they started to believe the stock market will drop by 10% next week–why it would drop by 10% right now. This common sense is the heart of rational expectations models.

So the correct conclusion is that our–and your–inability to predict the crisis confirms our theories. I feel a little like a physicist at the cocktail party being assured that everything is relative. That isn’t what the theory of relativity says: it says that velocity is relative.

Acceleration is most definitely not. So were you to come forward with the puzzling discovery that acceleration is not relative…

Of course some people did predict the crisis. Some might even have been smart enough to know that if they consistently predict the opposite of a consensus point forecast, eventually they will be right when everyone else is wrong. If I say every year: there will be war; there will be an asset market crash; there will be a recession; there will be famine; we will run out of oil – eventually I’ll be right. These kind of predictions are only meaningful if more people than can be attributed to random good luck got it right at the right time or if whatever method they used to reach that conclusion is replicable. Or does the ability to replicate results fall under the category of “not very interesting because that would be an elegant theory?”

But let’s turn to what you say are our deeper failures. We “turned a blind eye to the limitations of human rationality that often lead to bubbles and busts.” It makes me feel physically ill that a distinguished economist could be so ignorant of his own profession. As a random example, how about my student Felipe Zurita’s thesis on speculation written in 1998? There are endless papers written about bubbles and busts–some assuming rationality, some not. Some are experimental, some are theoretical, some are empirical. There are economists who have devoted their entire careers to studying bubbles. There is a fellow named Stephen Morris. He isn’t what you would call a fringe member of the economics profession–he’s the editor of Econometrica which, as you know, is one of the leading journals in economics. He has written extensively about bubbles. I take it you aren’t familiar with his work. Perhaps you should walk down the hall and stick your head in his office and ask him about it? Each crisis–in Mexico, in South-east
Asia, in Argentina–had generated hundreds of papers examining how and why the crisis took place.

Efficient markets? Where have you been for the last quarter century? The modern theory of how financial markets incorporate information is that they do so imperfectly. The technical device is that of noise traders originating in a 1985 paper of Admati. But I
think you knew of the idea earlier. In 1980 when you were a visitor at MIT, you participated in a graduate student seminar…in which I presented a paper starring noise traders…

Do we really need some sort of behavioral model to understand why asset prices fall abruptly? If opinions about asset values change, prices must fall abruptly–it isn’t irrational to run for the exits when the theater is on fire. In addition to a beautiful 1983 paper of Steve Salant there is a large literature on bank runs and contagion, not to speak of credit and collateral cycles. If there was some sort of irrationality involved in a panic, prices ought to bounce right back the next day when everyone wakes up and sheepishly realizes that they were wrong. In fact asset prices seem to be tracking news of fundamentals pretty well–gradually recovering as we get better news
about fundamentals.

Has behavioral economics offered anything that would help to solve the market failures that characterized this crisis? Was it herd behavior or animal spirits? Or was it risks that were not being priced?  Serious economists like Lasse Pedersen try to analyze how liquidity risks created systemic problems and think about how to incorporate them into our understanding of how to ameliorate future crises.  They don’t shake their heads and revert to discredited static theories of the 1930’s.

Crises have been ubiquitous throughout history. While we can’t forecast them we do know how to learn from them. And we certainly have a good idea what not to do in response: do what Chile did successfully–fail banks and recycle them, not do what Japan did unsuccessfully–keep the zombie banks limping feebly around. Like me you saw the bank bailout plan for what it was – not a necessary step to save the credit sector from collapse but a give-away of taxpayer money to investment bankers. But the stimulus plan? How can you be arguing for more? Since we are recovering before most of the stimulus money has entered the economy – isn’t that evidence it isn’t needed? How can you write as if you are proven right in supporting it?

Regards,

David