## Must-read: Nick Rowe: “Capital Theory and the Distribution of Income”

Must-Read: Nick Rowe provides a very brief masterclass in “capital theory”, which is really the theory of the price system not just at a point in time but over time. (Cf. (1975): Capital Theory and the Distribution of Income.) Needless to say, there is no presumption that there is only one equilibrium vector for the intertemporal price system. And there is no presumption that problems of aggregation for commodities called “capital” is any easier than problems of aggregation for commodities called “labor” or “services” or “nondurable goods”. (The question of whether the problems of aggregation for commodities called “capital” is any more difficult than for any other not-completely-unreasonable grouping is left as an exercise):

: Interest, Capital, MRScc=(1+r)=1+(MPK/MRTci)+(dMRTci/dt)/MRTci: “The slope of the indifference curve [is] the Marginal Rate of Intertemporal Substitution…

…between consumption this year and consumption next year. Call it MRScc…. The slope of the PPF [is] the Marginal Rate of Intertemporal Transformation, between consumption this year and consumption next year. Call it MRTcc. The equilibrium condition is: MRScc = (1+r) = MRTcc…. We don’t need ‘capital’, or its marginal product, to determine the rate of interest…. Where is ‘capital’ in this model? And where is the Marginal Product of Kapital? Does MPK determine r? Does MPK=r? ‘No’, is the answer to both those questions.

The equilibrium condition is MRScc=(1+r)=MRTcc. MPK is one of the things, but not the only thing, that affects MRTcc. And MRTcc is equal to (1+r), but it does not determine (1+r)…. MPK is defined as the extra apples produced per extra existing machine, holding technology and other resources constant, and holding the production of new machines constant. If we move along the PPF between consumption and investment this year, we will have a bigger stock of capital goods next year, which will shift out next year’s PPF. MPK tells us how much it shifts out, per extra machine….

If capital exists, the real rate of interest is equal to, but not determined by, the Marginal Product of Kapital divided by the real price of the machine, plus the capital gains from appreciation of the real price of machines…. Rather than saying ‘MPK determines r’, it would be more true to say ‘MRScc determines r, which determines the prices of capital goods’. And the only thing wrong with saying that is that is that MRScc… depends on the expected growth rate of consumption, which in turn depends on our ability to divert resources to producing extra capital goods instead of consumption goods, and the productivity of those extra capital goods…

## Must-read: Bernard Weisberger and Marshall Steinbaum: “Economists of the World, Unite!”

Must-Read: : Economists of the World, Unite!: “The original draft of that [American Economic Association] founding document…

…stated the group’s objectives as the encouragement of economic research and of ‘perfect freedom in all economic discussion.’ Then it went on:

We regard the state as an educational and ethical agency whose positive aid is an indispensable condition of human progress. While we recognize the necessity of individual initiative in industrial life, we hold that the doctrine of laissez-faire is unsafe in politics and unsound in morals; and that it suggests an inadequate explanation of the relations between the state and the citizens. We do not accept the final statements which characterized the political economy of a past generation…. We hold that the conflict of labor and capital has brought to the front a vast number of social problems whose solution is impossible without the united efforts of Church, state, and science.

This undisguised manifesto of rebellion against the economic orthodoxy of the Gilded Age raised eyebrows among the established preachers of ‘political economy.’ The state as an ‘ethical agency’ whose aid was ‘indispensable’? The ‘conflict of labor and capital’? Even after the denunciation of laissez-faire as ‘unsafe in politics and unsound in morals’ was removed from the final document, lest it appear that the new association had any motives beyond scientific advancement, the AEA was still understood as a challenge to the status quo. Indeed, the AEA was founded both to conduct scientific research and to agitate for reform, both inside academia and in the public sphere. At its start, the two missions were inextricably linked…

## Must-read: Jan Eberly and Jim Stock: “Spring 2016 BPEA”

Must-Read: : Spring 2016 BPEA: “We have arranged the following program…

…Jesse Bricker [et al.]… on ‘Measuring Income and Wealth at the Top Using Administrative and Survey Data’. David M. Byrne [et al.]… on ‘Does the United States have a Productivity Problem or a Measurement Problem?’. Alberto Cavallo [et al.]… on ‘Learning from Potentially Biased Statistics: Household’s Inflation Perceptions and Expectations in Argentina’. Melissa Kearney… and Phillip Levine… on ‘Income Inequality, Social Mobility, and the Decision to Drop Out of High School’. Deborah Lucas… on ‘Credit Policy as Fiscal Policy’. Raven Molloy [et al]… on ‘Understanding Declining Fluidity in the U.S. Labor Market’…

## Must-watch: Thomas Piketty, Paul Krugman, and Joseph Stiglitz: “The Genius of Economics”

Must-Watch: Mark Thoma sends us to: : The Genius of Economics: “Piketty, arguably the world’s leading expert on income and wealth inequality…

…does more than document the growing concentration of income in the hands of a small economic elite. He also makes a powerful case that we’re on the way back to ‘patrimonial capitalism,’ in which the commanding heights of the economy are dominated not just by wealth, but also by inherited wealth, in which birth matters more than effort and talent,’ wrote Paul Krugman in The New York Times. Krugman and his fellow Nobel laureate Joseph Stiglitz (author of The Great Divide) join Piketty to discuss the genius of economics.

## Must-read: Robert Axtell (2005): “The Complexity of Exchange”

Must-Read: (2005): The Complexity of Exchange: “The computational complexity of two classes of market mechanisms is compared…

…First the Walrasian interpretation in which prices are centrally computed by an auctioneer. Recent results on the computational complexity are reviewed. The non-polynomial complexity of these algorithms makes Walrasian general equilibrium an implausible conception. Second, a decentralised picture of market processes is described, involving concurrent exchange within transient coalitions of agents. These processes feature price dispersion, yield allocations that are not in the core, modify the distribution of wealth, are always stable, but path-dependent. Replacing the Walrasian framing of markets requires substantial revision of conventional wisdom concerning markets.

## Must-read: Noah Smith: “Book Review: ‘Economics Rules'”

Must-Read: : Book Review: “Economics Rules”: “I love a good book about econ philosophy-of-science…

Economic Rules: The Rights and Wrongs of the Dismal Science, by Dani Rodrik, is my favorite book in this vein to come out in quite some time…. I do have one big problem: the first two chapters. These chapters consist entirely of Rodrik’s very general thoughts on economic models, and what they should and shouldn’t be used for. The problem with these early chapters is the audience. Economists will already have heard most or all of these philosophical ideas. Non-economists, in contrast, will probably not understand…. These early chapters… fall into an uncanny valley, too old-hat for economists but too inside-baseball for non-economists.  So I fear that many readers may get turned off early….

Rodrik really shines when he talks about his own field, development econ. He gives a vivid recounting of the Washington Consensus – why it was adopted, why it went wrong, and how the mistakes could have been avoided. The story of the Washington Consensus provides the perfect backdrop for Rodrik’s ideas about what economists and models should do. The episode demonstrates why it’s important for policy advisors to look at a bunch of alternative models, and use personal judgment to choose which ones to use as analogies for reality. It is the perfect example of the ‘models as fables, economists as doctors’ worldview that Rodrik is trying to lay out. In fact, I wish more of the book had been about trade and development….

I find myself pretty much in agreement…. It’s very difficult to sum them all up (so go read the book), but here’s a few that really stood out: Rodrik notes that economists tend to present a much more simplistic, pro-market stance to the public than they show in their research and behind closed doors…. Rodrik strongly criticizes the New Classical and RBC macro theorists…. Rodrik tries to counter the criticism that economists ignore things like norms. In doing so, he basically says ‘The evidence shows that norms often matter, and economists pay attention to the evidence.’… This is a great book, and a quick read. Get it and read it if you haven’t.

## Must-read: Nick Rowe: “Neo-Fisherian Equilibrium with Upper and Lower bounds”

Must-Read: At least this has produced some useful work in how to teach the ignorant today things about convergence to equilibrium that Frank Fisher, Tom Sargent, and many others knew very well back at the end of the 1970s:

: Neo-Fisherian Equilibrium with Upper and Lower bounds: “Naryana [Kocherlakota]… [thinks] models should have relatively robust predictions….

If what happens in the limit is totally different from what happens at the limit, we have a problem…. If each boy racer had wanted to drive at 90% of the average speed, we get exactly the same Nash equilibrium, where they all drive at 0km/hr and stay in Ottawa, only now it’s a ‘stable’ equilibrium. We do not get multiple equilibria by adding an upper (or negative lower) bound to their speed. Any plausible equilibrium should be like that; it should be robust to minor changes in the boundary conditions. But if each boy racer wants to drive at 110% of the average speed, so driving at 0km/hr becomes an unstable equilibrium, adding boundary conditions creates new equilibria that are more plausible than the original unstable equilibrium, simply because they are stable….

We can see what Narayana is doing, when he considers a finite horizon version of the same game, as being like adding boundary conditions. If the game’s equilibrium is very fragile when you add or subtract or change those boundary conditions, there is something wrong with that equilibrium. We ought to get the same results in the limit as at the limit. If we don’t, we have a problem. Something like the Howitt/Taylor principle (or controlling a monetary aggregate or NGDP rather than a nominal interest rate) can convert an unstable equilibrium into a stable one.

Must-Read: : Can Economics Change Your Mind?: “Work from David Autor, David Dorn, and Gordon Hanson has convinced me that in some local areas…

…the job losses from free trade can be substantial, and that these communities have been slower to adjust than I expected…. Mark Zandi… tells me the paper ‘Potential Output and Recessions: Are We Fooling Ourselves?’ by Robert Martin, Teyanna Munyan, and Beth Anne Wilson changed his mind recently… that recessions tend to have a permanent negative effect on output…. Raj Chetty and John Friedman were skeptical of standardized test-based measures of teacher performance, and they set off to do research… their evidence convinced them they were wrong…. Amy Finkelstein… [found] people changed behavior and used less healthcare when they moved from geographies where people on average spend a lot on healthcare to places with low spending…. Narayana Kocherlakota spent three years at the head of the Minneapolis Fed criticizing monetary policy as risking out-of-control inflation and unlikely to help the economy. Then in 2012, he made an about face, telling the New York Times that ‘a wave of research gradually convinced him that he was wrong.’… And some even take the step of repudiating their own earlier work…. Emily Oster… ‘Hepatitis B Does Not Explain Male-Biased Sex Ratios in China,’ with an abstract that concludes ‘…hepatitis B cannot explain skewed sex ratios in China, and the conclusions about this in Oster (2005) were incorrect’…

## Must-read: Lorcan Roche Kelly: “Today”

Must-Read: It is likely to be an exciting day at the dog track!

: Today: “Chinese stocks close just 29 minutes after open…

…after the CSI 300 Index fell more than 7 percent. The selloff was sparked after the central bank cuts its yuan reference rate by the most since August…. The Stoxx Europe 600 Index slid as much as 3.6 percent, the most since August, before trading 3.2 percent lower at 10:40 a.m. in London. Germany’s DAX Index is trading below 10,000 for the first time since October…. Contracts on the Standard & Poor’s 500 Index slid 2.2 percent to 1,938 as of 10:50 a.m. in London. U.S. markets closed lower yesterday following the release of the Fed minutes from the December meeting which provided little clarity…. U.S. oil futures in New York slid to the lowest in 12 years with West Texas Intermediate dropping as much as 5.5 percent before trading down 2.5 percent at \$33.12 a barrel at 11:13 a.m….

## (Early) Monday DeLong Smackdown: Larry Summers on how we know more than we write down in our lowbrow (or highbrow) economic models

: Thoughts on Delong and Krugman Blogs: “I think the issue is more on the supply side than the demand side…

…If I believed strongly in the vertical long run Phillips curve with a NAIRU around five percent and in inflation expectations responsiveness to a heated up labor market, I would see a reasonable case for the monetary tightening that has taken place. I am sure Paul and Brad are right that a desire to be ‘sound’ also influences policy.  I am not nearly as hostile to this as Paul. I think maintaining confidence is an important part of the art of policy.

A good example of where market thought is, I think, right and simple model based thought is I think dangerously wrong is Paul’s own Mundell-Fleming lecture on confidence crises in countries that have their own currencies.  Paul asserts that a damaging confidence crisis in a liquidity trap country without large foreign debts is impossible, because if one developed the currency would depreciate, generating an export surge.

Paul is certainly correct in his model, but I doubt that he is in fact. Once account is taken of the impact of a currency collapse on consumers’ real incomes, on their expectations, and especially on the risk premium associated with domestic asset values, it is easy to understand how monetary and fiscal policymakers who lose confidence and trust see their real economies deteriorate, as Olivier Blanchard and his colleagues have recently demonstrated.  Paul may be right that we have few examples of crises of this kind, but if so this is, perhaps, because central banks do not in general follow his precepts.

I do not think this is a pressing issue for the US right now. But the idea that policymakers should in general follow the model and not worry about considerations of market confidence seems to me as misguided as the view that they should be governed by market confidence to the exclusion of models.

Larry is taking the side that our economists’ models are primarily filing systems rather than truth-generating mechanisms. As I have already written twice in the past week, the question is: Are models properly idea-generating machines, in which you start from what you think is the case and use the model-building process to generate new insights? Or are models merely filing systems–ways of organizing your beliefs, and whenever you find that your model is leading you to a surprising conclusion that you find distasteful the proper response is to ignore the model, or to tweak it to make the distasteful conclusion go away?

Both can be effectively critiqued. Models-as-discovery-mechanisms suffer from the Polya-Robertson problem: It involves replacing what he calls “plausible reasoning”, where models are there to assist thinking, with what he calls “demonstrative reasoning”. in which the model itself becomes the object of analysis. The box that is the model is well described but, as Dennis Robertson warned,there is no reason to think that the box contains anything real. Models-as-filing-systems are often used like a drunk uses a lamp post: more for support than illumination.

In the real world, it is, of course, the case that models are both: both filing systems and discovery mechanisms. Coherent and productive thought is, as the late John Rawls used to say, always a process of reflective equilibrium–in which the trinity of assumptions, modes of reasoning, and conclusions are all three revised and adjusted under the requirement of coherence until a maximum level of comfort with all three is reached. The question is always one of balance.

The particular fight Larry wants to pick this weekend is over Paul Krugman’s Mundell-Fleming lecture, and Paul’s claim that a floating-rate sovereign that borrows in its own currency and is in a liquidity trap should not worry about maintaining “confidence”. Paul’s argument is that, in the model, pursuing aggressive expansionary policies will eat first to currency depreciation, then to an export boom, then to full employment, and only then will any downsides emerge. Thus the process can be stopped before it begins to generate risks. And it is only after full employment is attained that policy concern should shift to avoiding such risks.

Larry, however, says: We know things that are not in the model. Those things make Paul’s claim wrong.

My problem with Larry is that I am not sure what those things are. Paul notes that in normal times–away from the interest-rate zero lower bound–a loss of “confidence” in a country that floats its and borrows in its own currency an be contractionary:

Now,,, we can examine the effect of a loss of investor confidence… which we can view as a sudden stop… reduction in capital inflows at any given interest and exchange rate…. What would happen to a country with its own currency and a floating rate confronted with a foreign loss of confidence?… The depreciation of the currency at any given interest rate would increase net exports, and hence shift the IS curve out. This might be the end of the story. As I noted… however, the central bank might be concerned about the possible inflationary consequences of depreciation, and would therefore lean against it; in that case the MP schedule would shift up. So interest rates would rise due to rising demand for domestic goods and, possibly, tight money driven by inflation concerns. It is possible, if the latter motive is strong enough, that output could actually fall…

But, Paul says, at the zero lower bound things are different because the central bank has a cushion between what it wants the real interest rate to be and what the zero lower bound forces the real interest rate to be:

Right now the United States, the United Kingdom, and Japan are all stuck in the liquidity trap…. [with] policy… constrained by the zero lower bound…. This in turn means that any shift in the MP schedule, unless very large, won’t lead to a rise in interest rates…. All that matters is the rightward shift in the IS curve…. In short, under current conditions the much-feared loss of confidence by foreign investors would be unambiguously expansionary, raising output and employment in nations like the United States, the United Kingdom, and Japan…

It’s not clear what we know that is not in the model that would reverse this conclusion of Paul’s in the case of a floating exchange rate in a country that borrows in its own currency and happens to be in a liquidity trap. Paul notes that his conclusion goes against market wisdom:

Many people will, I know, object to this conclusion…. [It] seems very counterintuitive… and is very much at odds with what almost every policymaker and influential figure has been saying…. when I have tried laying out this argument to other economists, I have found that in general they recognize the point but argue that real-world complications mean that a sudden stop will nonetheless be contractionary even in countries with independent currencies and floating rates. Why? They offer a variety of reasons….

And Paul goes on:

The short-term/long-term interest rate distinction does not appear to offer any channel through which a nation with an independent currency can suffer a decline in output due to reduced foreign willingness to hold its debt….

Several commentators—for example, Rogoff (2013)—have suggested that a sudden stop of capital inflows provoked by concerns over sovereign debt would inevitably lead to a banking crisis…. [But] why, exactly… should [we] believe that a sudden stop leads to a banking crisis…. [It is] is only a problem for the banks if they have large liabilities denominated in foreign currency…. Inflation—and fear of inflation—is a potential channel through which sudden stops can end up being contractionary even for countries with independent currencies and domestic-currency debt…. Large foreign-currency debt can effectively undermine monetary independence, as can fears of depreciation-led inflation. However, the major nations with large debts but independent currencies don’t have large foreign-currency debt, and are currently quite remote from inflation pressure. So the crisis story remains very hard to tell.

I would say that the major nations with large debts don’t have large foreign-currency debt that we know of…