…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?

…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.

…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

…How do we get out of this bind? As the old joke goes, I wouldn’t start from here. We should have spent the years of cheap oil encouraging conservation; we should have spent the years of modest growth in medical costs reforming our health care system. Oh, and we’d have a wider range of policy options if the budget weren’t so deeply in deficit. So if any of these things does come to pass, we’ll just have to see how well an administration in which political operatives make all economic policy decisions, and the Treasury secretary is only a salesman, handles crises.

…I did a back of the envelope calculation which said that GDP in 2013 might be around 4% lower as a result of cuts in government consumption and investment…. Sebastian Gechert, Andrew Hughes Hallett and Ansgar Rannenberg… use a meta analysis… fiscal multipliers are larger in depressed economies… GDP was 7.7% lower by 2013…. been willing or able to counteract. Yet the speed at which those in charge of the Eurozone begin to realise the mistake that they have made is painfully slow. Take this recent Vox piece by Marco Buti and Nicolas Carnot…. The mistake there is simple. When monetary policy is stuck at the Zero Lower Bound… getting the fiscal gap right is important in the longer term, but in the short term it is the means by which you get the output gap to zero…. An additional complication… a country… too competitive relative to the rest of the Eurozone… needs to run a positive output gap… to generate the inflation that will correct that position, and vice versa. For that reason Germany needs a large positive output gap at the moment… therefore a much more expansionary fiscal policy…. So at both the aggregate and individual country level, the inappropriate bias towards fiscal contraction that caused huge losses in the Eurozone in the past continues to operate…

…which one do you turn to? Prime-age EPOP? U6-U3?… Definitely not a good measure right now: the unemployment rate…. The decline in U3 doesn’t seem to be matching up with the movements in the wage growth data…. How about the difference between U3 and the U6 measure of unemployment? Similar…. How about prime-age EPOP?… It works here. Looks to me that the up-tick in ECI growth seems to be happening around the same time as the up-tick in the growth of the prime-age EPOP…. I thought it was interesting how well prime-age EPOP did and that it tracked ECI so well.

…Temptation goods… generate positive utility for the self that consumes them, but not for any previous self that anticipates that they will be consumed…. The assumption… that the fraction of the marginal dollar that is spent on temptation goods decreases with overall consumption has a number of striking implications for the… behavior of the poor…. Predicted behaviors under the declining temptation assumption can help us explain some of the puzzling facts about the poor that have been emphasized in the recent literature.