Tag: Macroeconomics

My Sections: As Delivered: Fed Up Rethink 2% Inflation Target Blue-Ribbon Commission Conference Call

Posted on by Brad DeLong

Opening Statement (as Delivered): I digress from my job here to say that I agree with everything that Jason and Josh have said. They do not speak just for themselves. They speak for me as well.

And let me also digress by trumping both Jason and Josh.

They both said “if you thought a 2% inflation target was appropriate a decade ago”. A decade ago I did not think a 2% inflation target was appropriate.

It was twenty-five years ago this summer that Larry Summers and I went to the Federal Reserve’s conference at Jackson Hole to say, among other things, that we thought it would be extremely risky and inappropriate to drop the Fed’s informal inflation target from its then-five percent to two percent. The 1990 savings and loan crisis was a small macroeconomic shock. Yet the Federal Reserve cut short-term interest rates by 600 basis points to respond to it. If there were ever a big shock, we said, the Fed would want all that much room to maneuver and more. It would not have that room to maneuver with a two percent inflation target.

So I’ve been beating this drum for twenty-five years off and on, and feeling very Cassandra-like for the past decade.

Now on to my job here. It is to get all medieval, in the sense of Thomas Aquinas, on you. It is to deal with the objections to our position, and then to provide what we believe are sufficient answers to those objections.

I hear four arguments for not changing the 2%/year inflation target, even though pursuing that target found us in a situation where monetary policy was greatly hobbled in its ability to manage the economy for a solid decade. And, as best as I can evaluate them, all four of these arguments seem to me to be wrong. They are:

The Federal Reserve, even at the zero lower bound, has powerful tools sufficient to carry out its stabilization policy tasks (Cf.: Mankiw and Weinzierl (2011) https://scholar.harvard.edu/files/mankiw/files/exploration_of_optimal.pdf), so moving away from 2%/year as a target is not necessary. This leaves begging the questions of why, then, employment has been so low over the past decade and why production is still so low relative to our circa-2007 expectations.

The problem is not the 2%/year target but rather pressure on the Federal Reserve: pressure from substantial numbers of economists and politicians practicing bad economics and motivated partisan reasoning. (As an example, somebody sent me a video clip this week of the very smart Marvin Goodfriend half a decade ago, arguing that faster recovery required the Fed to hit the economy on the head with a brick to make people more confident in its willingness to fight inflation http://www.bradford-delong.com/2017/06/on-the-negative-information-revealed-by-marvin-goodfriends-i-dont-teach-is-lm.html.) This ignores the Fed’s long institutional history of being willing to ignore outside pressure as it performs its standard monetary policy task of judging what appropriate interest rates are. Pressure only mattered when we got into “non-standard” monetary policies, which we needed to do only because the low inflation target had caused us to hit the zero lower bound.

At 2%/year, inflation is non-salient: nobody worries about it. A higher inflation rate would bring shifting expectations of inflation back into the mix, distract people and firms from their proper task of calculating real costs and benefits to worry about monetary policy, and make monetary policy management more complicated. But right now people and firms are “distracted” by the high likelihood of depressions that last longer than five years. That is a much bigger distraction than worrying about whether inflation will be 4%/year of 5%/year. And right now the zero lower bound makes monetary policy management much more complicated than it was back in the 1990s when the impact of Fed policy on inflation expectations was in the mix.

The Federal Reserve needs to maintain its credibility, and if it were to even once change the target inflation rate, its commitment to any target inflation rate would have no credibility. But the credibility you want to have is credibility that you will follow appropriate policies to successfully stabilize the economy—not credibility that you will mindlessly pursue a destructive policy because you think it somehow wrong to acknowledge that the considerations that led you to adopt it in the first place were wrong or have changed. As my friend Daniel Davies puts it in his One-Minute MBA Course: “Is a credible reputation as an idiot a kind of credibility really worth having?” http://crookedtimber.org/2006/11/29/reputations-are-made-of/

Over to you, Joe…

* * * *

Answers to Questions: There is no unemployment rate target right now.

The Federal Reserve thinks about what the non-accelerating inflation rate of unemployment might be. But they claim not to have any strong view. They claim to be guided by the data, in terms of assessing how much pressure the economy can take. By contrast, the Federal Reserve had an informal inflation target of four to five percent per year in the late 1980s and early 1990s. And it then shifted down first, in the mid-1990s, to an informal target of two percent per year for the core PCE index under Alan Greenspan. It then formalized that under Bernanke in the late 2000. If they did have an unemployment rate target to talk about, we would be talking about that as well. But they don’t.

The question is a very good one. When I come write the economic history of the 2010s, I think that both Ben Bernanke and Janet Yellen are likely to be judged quite harshly. Once the recession of 2008-2009 had reached its end, the Federal Reserve had one overwhelming first priority: to create a strong enough economy that it could sustain short-term safe nominal interest rates of 400 to 500 basis points, and still grow at potential, in order that the Federal Reserve would have room to deal with the next recessionary shock when it came by conventional interest rate policy. The Federal Reserve did not prioritize that objective. Now here we are, late in a recovery, with short-term safe interest rates at 80 basis points or so, and with substantial fear that the economy is not robust enough to support any substantial rise over the time before the next severe recessionary shock hits. Indeed, an attempt to push short-term rates higher in the near future might well be such a recessionary shock.

The Federal Reserve has wedged itself into a position where it has almost no conventional monetary policy ammunition to deploy.

Let me say that the housing bubble did not blow up the economy. Let me say that the deflation of the housing bubble did not blow up the economy. As of the start of 2008, the housing bubble had collapsed, and all of the excess workers who had
been employed in construction had moved out and overwhelmingly found jobs in other sectors without even a small recession or more than a trivial rise in the unemployment rate.

But there was left in the bowels of the financial system the fact that the big money center banks had been playing regulatory arbitrage—claiming that the mortgage-backed securities they were holding were true AAA assets when they were nothing of the sort. It was this concentration of overvalued and mischaracterized assets in the highly leveraged money center banks that got us into big trouble, not the collapse of the housing bubble.

You can see this if you recall that the collapse of the dot-com bubble in 2000-1 took down about five times as much in the way of investors’ wealth as the collapse of the housing bubble took down the wealth of subprime lenders. And yet the 2000-1 bubble collapse did not cause a big recession. Why not? Because the people who took the hit were the rich equity investors in Silicon Valley, rather than the highly overleveraged money center banks that had decided to get a little bit too clever with how they characterized the assets they were holding.

Note that there are people like Larry Summers and Olivier Blanchard who are right now much more on now on Team Expansionary Fiscal Policy than on Team Raise the Inflation Target, in substantial part because of a desire to keep inflation non-salient and because our understanding of how bubbles are generated and what role ultra-low interest rates and quantitative easing play in generating them is very poor.

Let me underscore Jason’s point: Marvin Goodfriend is a potential future nominee to the Federal Reserve Board. Marvin Goodfriend has a remarkable aversion to and suspicion of quantitative easing. But has been very comfortable with the Federal Reserve’s interest rate management role.

When I have pitched this idea of a blue-ribbon examination of the proper inflation target in the past, what I have believed was my cleverest thought was to make Ben Bernanke and Larry Summers co-chairs, and make them in charge of figuring out where the rough consensus of—once again getting Thomas Aquinas on you—the greater and wiser part of the informed community of thinkers about this is.

I have to run to two pointless bureaucratic meetings. If you have any more questions, please email me at delong@econ.berkeley.edu, and if I can hide my phone keyboard and use my thumbs I will answer during the meetings, and if not I will answer as soon as I can afterwards.

And one thing I did not say: We have had four pieces of bad news in the past decade, all of which strongly argue against preserving the two percent per year core PCE inflation target. They are:

  1. bad news about the value of the Wicksellian neutral interest rate.
  2. bad news about the public sphere’s understanding of what the non-interest rate macroeconomic policy tools are and how to deploy them.
  3. bad news about partisanship—the solid opposition of the Republican Party to the policies of South Carolina Republican Ben Bernanke because it was thought they might redound to the benefit of Obama.
  4. bad news about the strength of non-standard stimulative monetary policies.

More References:

On the Negative Information Revealed by Marvin Goodfriend’s “I Don’t Teach IS-LM”

Posted on by Brad DeLong

The smart and snarky Sam Bell wants to taunt me into rising to his bait by twittering https://twitter.com/sam_a_bell/status/872116967070732288 a quote from likely Fed nominee Marvin Goodfriend: “I don’t teach IS-LM”. He succeeds. Here is the quote:

TOM KEENE: But, Marvin, with, you know, basic IS-LM and theory and all that stuff you teach in Economics 101, aren’t we going to see a dampening of GDP if we see a restrictive Fed?

MARVIN GOODFRIEND: By the way, I don’t teach IS-LM. But what I would say is this…

And here is the tape:

March 23, 2012: https://www.youtube.com/watch?v=emvSYwUnWyI&ab_channel=Bloomberg

Let me start by analyzing “I don’t teach IS-LM”. And let me preface this by saying that Marvin Goodfried is a very sharp and honest economist. But I believe that whenever anybody says “I don’t teach IS-LM” they are one of:

  1. Making completely implausible and wrong claims about how the economy works.
  2. Being lazy and/or stupid.
  3. Declaring a tribal affiliation to a particular Carnegie-Mellon tradition of macroeconomic analysis that the late Rudi Dornbusch described to me and others as “Jim Tobin with original errors”, and that I think has shed a lot more heat than light on real issues.

Let us start with (1), and let us start with Irving Fisher’s monetarism: the quantity of money demanded in the economy is given by the equation:

Md = PY/V

where M is the quantity of money demanded, P is the price level, Y is the level of production, and V is the velocity of money—the value of transactions that having $1 in the bank or in cash as money can support, in the sense of manufacturing the needed trust so that the transactions will go through.

If you believe that that velocity of money is fixed by the institutions of the banking system and the technology supporting transactions, then you do not have to teach IS-LM. You have reached a full stop, and have the monetarist conclusion that the total nominal spending in the economy—prices times quantities produced—is equal to a constant times the economy’s money stock, with the constant of proportionality chaining slowly over time as the institutions of the banking system and the technology supporting transactions slowly changes.

That is meaning (1) of “I don’t teach IS-LM”: I do not need to teach it because it is not important in determining how much spending there is the economy. That is implausible and wrong. Here is the graph of velocity since 1960—the thing that is supposed to be on a smooth and steady time trend if “I don’t teach IS-LM” is a sensible thing to say:

Velocity of M2 Money Stock FRED St Louis Fed

Even before the 1990s any model assuming an unproblematic relationship between the money stock and total spending was badly awry, although not as badly awry as it has been since.

Now let’s move on to (2)—lazy and/or stupid. The graph above tells you that if you want to forecast—or even retrospectively explain—the relationship between the money stock and the level of spending, you need a model of what the determinants of the fluctuations of velocity we see are. If we draw a graph with the level of spending on the horizontal axis and some sufficient statistics for the determinants of velocity on the vertical axis, the path traced out by our equation:

Md = PY/V

is conventionally called “the LM curve”. But you then need to know where on the LM curve the economy will be—you need another curve. And that other curve is conventionally called “the IS curve”.

To claim that you do not teach IS-LM is to implicitly claim that you do not need to figure out where on the LM curve the economy will be. That is something it is only possible to say if you are being lazy, or stupid.

The third meaning of “I don’t teach IS-LM” is that it is a CMU-school tribal indentification marker, and has no purpose beyond that—no intellectual purpose.

So, yes, the fact that Marvin Goodfriend would go on Tom Keene’s surveillance and say “I don’t teach IS-LM” makes me think a good deal less of him. I do, however, interpret that claim as a declaration of tribal allegiance to CMU-school macro. I do not interpret it as a claim that you don’t need a model of the determinants of fluctuations in velocity. I do not interpret it as a claim that there are no fluctuations in velocity large enough to worry about.

What worries me more, however, is what comes next:

GOODFRIEND: There is no way that this recovery can proceed with any degree of confidence unless the Fed makes sure that inflation does not move up. So I think the risks are exactly reversed from the way the Fed chairman discusses this. He has to make the public understand that any whiff of doubt about the Fed’s ability and willingness to stabilize inflation is going to put a crimp into the public’s willingness to take positions and commitments over the next two or three years that would produce genuine growth. And so I would just take it, and turn it on its head, and not put the question as you did to me, but reverse it.

The risks of allowing any latitude in inflation expectations to build dup, or any doubt about the Fed’s willingness to do what it takes to keep inflation down, is to me the most likely risk in preventing this recovery from getting any traction…

Do notice that Marvin Goodfriend is, here, thinking in terms of an IS-LM model. When he says “any whiff of doubt about the Fed’s ability and willingness to stabilize inflation is going to put a crimp into the public’s willingness to take positions and commitments… is to me the most likely risk in preventing this recovery from getting any traction…”, he is saying: “any whiff of doubt about the Fed’s ability and willingness to keep inflation low will cause a large leftward shift in the IS curve that will prevent this recovery from getting any traction…” He does not do more than gesture at an expectational mechanism for this leftward shift in the IS curve that he wants the Federal Reserve to take action to head off. But it is what he fears.

And, of course, Goodfriend was wrong: a continuation of Bernanke’s extraordinary easing policies was not going raise “any whiff of doubt about the Fed’s ability and willingness to stabilize inflation”.

Here we have a market-based measure of inflation expectations—the ten-year breakeven inflation rate since 2010: that inflation rate over the forthcoming ten years that would, at each date, have made investments in conventional Ten-Year U.S. Treasury bonds and investments in Ten-Year Inflation-Protected Securities (TIPS) equally profitable. The vertical blue line marks March 23, 2012: the date of Marvin Goodfriend’s interview. The point that Marvin was hammering home again and again on March 23, 2012 was that the Federal Reserve needed to rapidly start shrinking its balance sheet and raising interest rates lest inflation expectations break out to the upside.

The Federal Reserve ignored Marvin Goodfriend.

And Marvin Goodfriend was wrong. The shift to a tighter, more restrictive policy he demanded then was not necessary to prevent an upside breakout of inflation expectations.

In fact, the Federal Reserve’s persistent problem since has been that expectations of—and actual outcomes for—inflation have been well below rather than above the Federal Reserve’s targets.

I would very much like to hear Marvin Goodfriend explain why he misjudged the situation in the spring of 2012, and how he has updated his view of the economy and of optimal monetary policy since.

The Truth Behind Today’s US Inflation Numbers

Posted on by Brad DeLong

Live at Project Syndicate: The Truth Behind Today’s US Inflation Numbers https://www.project-syndicate.org/commentary/fed-low-inflation-more-stimulus-by-j–bradford-delong-2017-06: BERKELEY – In December 2015, the US Federal Reserve embarked on a monetary-tightening cycle, by raising the target range for the short-term nominal federal funds rate by 25 basis points (one-quarter of a percentage point). At the time, the Federal Open Market Committee (FOMC)–the Fed body that sets monetary policy–issued a median forecast predicting three things… Read MOAR at Project Syndicate

On Keynesian Economicses and the Economicses of Keynes: Hoisted from June 2, 2007

Posted on by Brad DeLong

Hoisted from June 2, 2017: On Keynesian Economicses and the Economicses of Keynes http://www.bradford-delong.com/2007/06/keynesian_econo.html: With respect to http://bookclub.tpmcafe.com/blog/bookclub/2007/jun/01/rebutted_but_not_refuted…

I think that there are two ways to understand the divergence of perspectives here…

The first is to note that Jamie Galbraith sees Keynes’s General Theory as part of something bigger: combine it with John Kenneth Galbraith’s New Industrial State, with Hyman Minsky’s approach to financial crises, and perhaps with Piero Sraffa’s Production of Commodities by Means of Commodities, and you do have an alternative theoretical framework for economics that owes very, very little to the Marshallian or even the Smithian tradition—and that owes nothing at all to the Walrasian tradition.

Call this “East Anglian Keynesianism.”

My macroeconomics teachers—Kindleberger, Eichengreen, Dornbusch, Fischer, Abel, Blanchard, Sargent—by contrast, see Keynes’s macroeonomics (not just the single book that is the General Theory, but also How to Pay for the War, The Economic Consequences of Mr. Churchill, the Tract on Monetary Reform, and so forth) as part of a different bigger thing. They see Keynes, Wicksell, and even Milton Friedman (though he would rarely admit it) as all groping toward an understanding of the macroeconomy that ends in the belief that limited, strategic, focused, yet powerful government interventions can create a situation in which the market economy could then work more-or-less along Smithian lines—that these focused government policies can, as I like to say, make Say’s Law true in practice even though it is false in theory.

Call this “MIT Keynesianism.”

MIT Keynesianism tends to downplay the most Galbraithian moments of Keynes—for example, his cracks about how bankers would prefer to fail in a conventional manner than to profit and grow rich in an unconventional manner. They regard the General Theory as just one of Keynes’s works written at a particular time (one of Great Depression) and thus focusing on the issues of greatest importance at that particular historical moment.

East Anglian Keynesianism throws Keynes’s earlier work out the window, and argues that the General Theory marks a genuine epistemological and theoretical break. But it has severe and serious problems with passages in the General Theory like this one, which Keynes puts at the very end of the book, where he argues that his theory is:

moderately conservative…. The State will have to exercise a guiding influence on the propensity to consume partly through its scheme of taxation, partly by fixing the rate of interest…. I conceive… that a somewhat comprehensive socialisation of investment will prove the only means of securing an approximation to full employment; though this need not exclude all manner of… devices by which public authority will co-operate with private initiative…. Our criticism of the accepted classical theory of economics has consisted… in pointing out that its tacit assumptions are seldom or never satisfied, with the result that it cannot solve the economic problems of the actual world. But if our central controls succeed in establishing an aggregate volume of output corresponding to full employment… the classical theory comes into its own… then there is no objection to be raised against the classical analysis of the manner in which private self-interest will determine what in particular is produced, in what proportions the factors of production will be combined to produce it, and how the value of the final product will be distributed between them… no objection…against the modern classical theory as to the degree of consilience between private and public advantage in conditions of perfect and imperfect competition respectively…. [T]he result of filling in the gaps in the classical theory is not to dispose of the ‘Manchester System’, but to indicate the nature of the environment which the free play of economic forces requires…. [T]here will still remain a wide field for the exercise of private initiative and responsibility. Within this field the traditional advantages of individualism will still hold good.

Let us stop for a moment to remind ourselves… [of] the advantages of efficiency—the advantages of decentralisation and of the play of self-interest… and of individual responsibility…. [A]bove all, individualism, if it can be purged of its defects and its abuses, is the best safeguard of personal liberty…. It greatly widens the field for the exercise of personal choice… the best safeguard of the variety of life… the loss of which is the greatest of all the losses of the homogeneous or totalitarian state. For this variety preserves the traditions which embody the most secure and successful choices of former generations; it colours the present with the diversification of its fancy; and, being the handmaid of experiment as well as of tradition and of fancy, it is the most powerful instrument to better the future…

And this one from the start of chapter 2 of the General Theory:

[O]rdinary experience tells us, beyond doubt, that a situation where labour stipulates (within limits) for a money-wage rather than a real wage, so far from being a mere possibility, is the normal case. Whilst workers will usually resist a reduction of money-wages, it is not their practice to withdraw their labour whenever there is a rise in the price of wage-goods. It is sometimes said that it would be illogical for labour to resist a reduction of money-wages but not to resist a reduction of real wages. For reasons given below (section III), this might not be so illogical as it appears at first; and, as we shall see later, fortunately so. But, whether logical or illogical, experience shows that this is how labour in fact behaves…

Thus not just Keynes’s earlier work, but chunks of the General Theory have to be purged and thrown overboard.

MIT Keynesianism does not claim that East Anglian Keynesianism is not “Keynesianism.” (It claims that it is not a fruitful research program, that given the world as it is pursuing its line of research is harmful to graduate students’ careers, and that its model-building practices lead to fuzzy thinking, but it doesn’t excommunicate East Anglian Keynesianism.)

By contrast, East Anglian Keynesianism does excommunicate MIT Keynesianism.

We’ve seen this here, with Thomas Palley’s claim that “[t]oday’s orthodoxy is laissez-faire neo-classical economics” and that “the last time a paper on macroeconomics with a Keynesian structure was published in the American Economic Review was in the early 1980s. Send in such a paper and it will be immediately rejected as “old” economics.”

Whatever you think of the MIT Keynesians, they were never laissez-faire—orthodoxy yes, neoclassical yes, but never laissez-faire.

My view is that, as a matter of the history of economic thought, the MIT Keynesians have the better of it. But my view is that both research programs are useful and both should be pursued (although I think the MIT Keynesian one has been more successful, and I find that I have a much easier time working within it), and that both are very far indeed from any form of laissez-faire.

The second way to understand the difference of perspectives is different.

It is to interpret Jamie Galbraith as noting that there are two right-wing reactions to Keynes’s: “The Economic Consequences of Mr. Churchill.”

The first is Milton Friedman’s reaction: if the problem is that Churchill as Chancellor of the Exchequer pursues a stupid monetary policy, the answer is to get Churchill’s hands off the steering wheel and make monetary policy automatic.

The second is Friedrich Hayek’s reaction: if the problem is that nominal wages cannot be easily forced down to their equilibrium level because the labor unions have too much bargaining power, the answer is to destroy the unions so that workers have no bargaining power to keep nominal wages sticky at all.

Now Keynes rejected both of these reactions. He wrote chapter 12 “The State of Long-Term Expectation” in the General Theory in order to say contra Friedman that “automatic” monetary policy cannot do the job. He wrote chapter 19 “Changes in Money Wages” to argue contra Hayek that sticky nominal wages are more likely to be a stabilizing than a destabilizing factor.

According to this second way of understanding this conversation, Galbraith is saying that modern orthodox establishment MIT Keynesianism gives much too little weight to ideas springing from chapter 12 and chapter 19, and seeks to build analytical bridges to—peacefully coexist with—both Friedmanite and Hayekian perspectives, to the extent that this is possible.Its Keynesianism is domesticated, in a process started by John Hicks with “Mr. Keynes and the ‘Classics’: A Suggested Interpretation”. It sees “Keynesian” ideas as a cloud in a two-dimensional continuum that shade into Friedmanite and even Hayekian ideas at their edges. The idea that this continuum hypothesis was wrong—that there was for all intents and purposes a complete epistemological break between Keynes and the classics—is essentially the criticism of establishment MIT Keynesianism made by Axel Leijonhufvud in hisOn Keynesian Economics and the Economics of Keynes.

If this is what Galbraith is saying, I agree with him–and I think others agree with him too: Mark Gertler, Ben Bernanke, Larry Summers, James Tobin, Stanley Fischer, Rudi Dornbusch, and Robert Shiller are the first names that spring to my mind…

Why Is the FOMC So Certain the U.S. Is “Essentially at Full Employment”?

Posted on by Brad DeLong
Employment Rate Aged 25 54 All Persons for the United States© FRED St Louis Fed

Suppose you had, back in 1992 or 2004 or indeed any other time since 1990 and before 2013, asked a question of Charlie Evans—or, indeed, any of the other non-Neanderthal participants in the Federal Reserve’s Federal Open Market Committee meetings. Suppose you had asked whether a 25-54 employment-to-population ratio in the United States of today’s 78.5% was anywhere near “full employment”. What would they have said?

They would have said “of course not!”

They would have observed that the post-baby boom decline in fertility, wage stagnation among male earners, and the coming of feminism had greatly increased the share of 25-54 year old women who wanted paying jobs outside the home.

They would have pointed out that upward pressure on core inflation at an 80% 25-54 employment-to-population ratio in 1990 was small, that upward pressure on core inflation at an 82.5% 25-54 employment-to-population ratio in 2000 was minimal, and that upward pressure on core inflation at an 80% 25-54 employment-to-population ratio in 2007 was minimal.

They would have pointed out that today’s 78.5% was between between the 78.1% 1992 recession trough and the 78.6% 2003 recession trough.

They would have concluded that, by the standards of the post-feminist revolution era, a labor market with a 25-54 employment-to-population ratio of 78.5% was a labor market as bad from a business cycle perspective as the labor market got during the Great Moderation.

So why is Charlie Evans now saying that today the United States has “essentially returned to full employment”? Why no qualifiers? Why no “if you look only at the unemployment rate, and put the shockingly-low labor force participation statistics to one side…? Why no “it may well be the case that the U.S. has essentially returned to full employment? Why this certainty on the part of even the non-Neanderthal members of the FOMC—in public, at least—that the unemployment rate is the sole guide?

And why the puzzlement at the failure of core inflation to rise to 2%? That is a puzzle only if you assume that you know with certainty that the unemployment rate is the right variable to put on the right hand side of the Phillips Curve. If you say that the right variable is equal to some combination with weight λ on prime-age employment-to-population and weight 1-λ on the unemployment rate, then there is no puzzle—there is simply information about what the current value of λ is:

Charles Evans: Lessons Learned and Challenges Ahead: “These policies… produced results. Unemployment began to fall… https://www.chicagofed.org/publications/speeches/2017/05-25-lessons-learned-and-challenges-ahead-bank-of-japan

…more quickly than anticipated in 2013…. We were able to scale back the QE3 purchases…. Today, we have essentially returned to full employment in the U.S.

Unfortunately, low inflation has been more stubborn, being slower to return to our objective. From 2009 to the present, core PCE inflation, which strips out the volatile food and energy components, has underrun 2% and often by substantial amounts. This is eight full years below target. This is a serious policy outcome miss…

Charlie says a lot of good things in his talk. His discussions of “outcome-based policies… symmetric inflation target[s]… [and] risk management” are wise. But wisdom can be usefully applied only if you know where you start from. And we start from a position in which we really do not know how close the U.S. economy is right now to “full employment”—how much headroom for catch-up growth and catch-up employment remains, and how powerful and useful more aggressive policies to stimulate spending would be right now.

In 25 years my students are likely to ask me why the FOMC was so certain the U.S. was “essentially at full employment” today. What will I tell them?

A Low-Pressure Economy Is Not Only Dark But Invisible in the Horserace Noah Smith is Running…

Posted on by Brad DeLong
Cursor and Cracking the Mystery of Labor s Falling Share of GDP Bloomberg View

I think the estimable Noah Smith gets this one wrong. He writes:

Noah Smith: Cracking the Mystery of Labor’s Falling Share of GDP: “Economists are very worried about the decline in labor’s share of U.S. national income… https://www.bloomberg.com/view/articles/2017-04-24/cracking-the-mystery-of-labor-s-falling-share-of-gdp

…For decades, macroeconomic models assumed that labor and capital took home roughly constant portions of output—labor got just a bit less than two-thirds of the pie, capital slightly more than one-third. Nowadays it’s more like 60-40. Economists are therefore scrambling to explain the change. There are, by my count, now four main potential explanations for the mysterious slide in labor’s share. These are: 1) China, 2) robots, 3) monopolies and 4) landlords…”

There is, in my view, a fifth—and a much more likely—possibility: the low-pressure economy.

The first misstep Noah takes is in saying that 100% of national income is divided between “labor” and “capital”. It is not. Entrepreneurship, risk-bearing, innovation, monopoly rents, and other factors are rolled into the non-labor share as well. It’s not the labor share and the capital share. It’s the labor share and everything else.

Suppose that you were not attached to sophisticated economic theory but just believed in the basic Adam Smith supply-and-demand: when something is in high demand, its price goes up; when something is in low demand, its price goes down. How then would you interpret the graph above at the top of this post?

You would say:

  1. Hmmm. In the late 1960s Lyndon Johnson created a high-pressure economy—he did not want to raise taxes to pay for fighting the Vietnam War, and did not want the Federal Reserve to raise interest rates. Then Richard Nixon continued the policy, naming Arthur Burns his own partner in his attempt in 1959 to persuade Eisenhower to create a high-pressure economy for the 1960 campaign, to run the Federal Reserve. And so the labor share went up.

  2. The 1973-1975 oil shock recession and then the 1979-1982 Iran Revolution plus Volcker Disinflation recessions gave a further large negative wallop to the pressure the economy was under. And so the labor share fell.

  3. It may have been “morning in America” from 1984 on in Reagan campaign commercials, but that was definitely not the case as far as the labor market was concerned.

  4. When the labor market became tight again in the internet boom of the late 1990s, lo and behold the labor share jumped back up again.

  5. But the recovery from the recession that followed the dot-com boom and 9/11 was a disappointing one. And the labor share fell.

  6. And then came the financial crisis and the disappointing recovery since. And the labor share fell some more.

Noah Smith’s quadriad of “China, robots, monopolies, and landlords” is needed only if you have a strong belief that there is one unique macroeconomic equilibrium point about which the business cycle fluctuates and to which the economy returns rapidly after a business-cycle shock creates a high- or a low-pressure economy. It is certainly convenient for economic model builders to believe in such a tendency for a rapid return to a unique macroeconomic equilibrium.

But where in the real world is there any evidence that there is in fact such a thing?

IMHO, the low-pressure economy is the leading horse in the race to understand why the labor share today is lower than it was in the late 1960s or the late 1990s. Yet Noah Smith does not even see it as in the race…

There Is an Old Joke About Economists, Keys, and Lampposts That Comes to Mind Here…

Posted on by Brad DeLong
Cursor and Lamppost 2 jpg

This is an interesting, if an Aesopian, article by Olivier Blanchard…

He says that we need five kinds of macroeconomic models. He then gives examples of the five kinds. The examples of four of the kinds track—foundational, policy, toy, and forecasting—and we do indeed need those four kinds.

Then we come to the fifth kind, which Blanchard introduces by saying that we need:

DSGE models. The purpose of these models is to explore the macro implications of distortions or set of distortions. To allow for a productive discussion, they must be built around a largely agreed upon common core, with each model then exploring additional distortions…

But two paragraphs down he writes, of all existing DSGE models:

The current core, roughly an RBC (real business cycle) structure with one main distortion, nominal rigidities, seems too much at odds with reality… the Euler equation for consumers and the pricing equation for price-setters…

What is he saying? That all existing DSGE models are worthless. We should throw them away, and start over with respect to building this fifth kind of model. We can call it “DSGE”, but it will not be what has—hitherto at least—been “DSGE”. In his view, it will have to have “nominal rigidities, bounded rationality and limited horizons, incomplete markets and the role of debt”—i.e., real rather than fake microfoundations.

The problem, of course, is that we cannot (yet) set out such a model in a sufficiently tractable form. Thus I think that one inescapable conclusion that we need to draw from Blanchard is that, for now, we need to keep using our four useful kinds of models—foundational, policy, toy, and forecasting. And I think a second inescapable conclusion we need to draw is that we should stop doing DSGE models which involve looking under the lamppost for the key where it is not. We need, rather, to disassemble the lamppost. And then some of us can use its pieces to try to build another lamppost, but this time locate it in a less silly and useless place.

Olivier Blanchard: On the Need for (At Least) Five Classes of Macro Models https://piie.com/blogs/realtime-economic-issues-watch/need-least-five-classes-macro-models: “We need different… five types…

…[of] general equilibrium models….

  1. Foundational models… the consumption-loan model of Paul Samuelson, the overlapping generations model of Peter Diamond…

  2. DSGE models… to explore the macro implications of distortions or set of distortions… built around a largely agreed upon common core, with each model then exploring additional distortions…. The current core, roughly an RBC… seems too much at odds with reality to be the best starting point…. How close [should] these models… be to reality[?]… They should obviously aim to be close, but not through ad-hoc additions and repairs, such as arbitrary and undocumented higher-order costs introduced only to deliver more realistic lag structures…

  3. Policy models. (Simon Wren-Lewis prefers to call them structural econometric models.)… For this class of models, the rules of the game must be different than for DSGEs. Does the model fit well, for example, in the sense of being consistent with the dynamics of a VAR characterization? Does it capture well the effects of past policies? Does it allow one to think about alternative policies?

  4. Toy models… IS-LM… Mundell-Fleming… RBC… New Keynesian model…. [To] allow for a quick first pass at some question, or present the essence of the answer from a more complicated model or class of models….

  5. Forecasting models. The purpose of these models is straightforward: Give the best forecasts…

All models should be built on solid partial equilibrium foundations and empirical evidence.

Why Were Economists as a Group as Useless Over 2010-2014 as Over 1929-1935?

Posted on by Brad DeLong

Let us start with two texts this morning:

Paul Krugman: Don’t Blame Macroeconomics (Wonkish And Petty): “Robert Skidelsky… argues, quite correctly in my view, that economists have become far too inward-looking…

…But his prime examples of economics malfeasance are, well, terrible…. [The] more or less standard model of macroeconomics when interest rates are near zero [is] IS-LM in some form…. [And] policy had exactly the effects it was “supposed to.” Now, policymakers chose not to believe this…. And yes, some economists gave them cover. But that’s a very different story from the claim that economics failed to offer useful guidance…

Simon Wren-Lewis: Misrepresenting Academic Economists: “The majority of academic macroeconomists were always against austerity…

…Part of the problem is a certain disregard for consensus among economists. If you ask most scientists how a particular theory is regarded within their discipline, you will generally get a honest and fairly accurate answer…. Economists are less likely to preface a presentation of their work in the media with phrases like ‘untested idea’ or ‘minority view’…. Part of Brad’s post it seems to me is simply a lament that Reinhart and Rogoff are not even better economists than they already are. But there is also a very basic information problem: how does any economist, let alone someone who is not an economist, know what the consensus among economists is? How do we know that the people we meet at the conferences we go to are representative or not?…

“Mainstream”, “academic”, and “majority” are doing an awful lot of work here for both Paul and Simon. So let me repeat something I wrote last December, in response to Paul’s liking to say that macroeconomics has done fine since 2007. Certainly Jim Tobin’s macroeconomics has. John Maynard Keynes’s macroeconomics has. Walter Bagehot, Hyman Minsky, and Charlie Kindleberger’s macroeconomics has done fine.

But Bagehot and Minsky influenced the then top-five American economics departments–Chicago, MIT, Harvard, Princeton, Yale–only through Kindleberger. Charlie went emeritus from MIT in 1976 and died in 1991, and MIT made a decision–a long series of repeated decisions, in fact–that there was no space on its faculty for anybody like Charlie.

When Robert Skidelsky says “macroeconomics”, he means the macroeconomics of RBC and DSGE and ratex and the Great Moderation.

And he is right: Alesina and Ardagna and Reinhart and Rogoff each had more influence on what policymakers and journalists thought about the effects of fiscal policy than did Paul Krugman and company, (including me). While the Federal Reserve went full-tilt into quantitative easing (but not stamped money or helicopter money), it did so in the face of considerable know-nothing opposition. And the ECB lagged far behind in terms of even understanding its mission. Why? Because economists Taylor, Boskin, Calomiris, Lucas, Fama, and company had almost as much or even more impact as did Paul Krugman and company.

“Basic macro” did fine. But basic macro was not the really-existing macro that mattered.

And let me repeat part of my public intellectuals paper: In the last days before the coming of the Roman Empire, Marcus Tullius Cicero in Rome wrote to his BFF correspondent Titus Pomponius Atticus in Athens:

You cannot love our dear [Marcus Porcius] Cato any more than I do; but the man–although employing the finest mind and possessing the greatest trustworthiness–sometimes harms the Republic. He speaks as if we were in the Πολιτεια of Plato, and not in the sewer of Romulus…

Whatever you may think about economists’ desires to use their technical and technocratic expertise to reduce the influence of both the Trotskys and the St. Benedicts in the public square, there is the prior question of whether here and now–in this fallen sublunary sphere, among the filth of Romulus–they have and deploy any proper technical and technocratic expertise at all. And we seem to gain a new example of this every week. The most salient relatively-recent example was provided by Carmen Reinhart and Kenneth Rogoff–brilliant, hard-working economists both, from whom I have learned immense amounts….

They believed that the best path forward for… the U.S., Germany, Britain, and Japan was… to shrink their government deficits quickly and quickly halt the accumulation of and begin to pay down government debt. My faction, by contrast, believed that the best path forward for these economies was for them to expand their government deficits now and let the debt grow until either economies recover to normal levels of employment or until interest rates begin to rise significantly…. [For example:]

[Carmen] Reinhart echoed [Senator] Conrad’s point and explained that countries rarely pass the 90 percent debt-to-GDP tipping point precisely because it is dangerous to let that much debt accumulate. She said, “If it is not risky to hit the 90 percent [debt-to-GDP] threshold, we would expect a higher incidence…”

I think we have by far the better of the argument. There is no tipping point. Indeed, there is barely a correlation, and it is very hard to argue that that correlation reflects causation from high initial debt to slower subsequent growth:

NewImage

Yet it is very clear that even today Reinhart and Rogoff–and allied points by economists like Alberto Alesina, Francesco Giavazzi, et al., where I also think we have the better of the argument by far–have had a much greater impact on the public debate than my side has.

Thus, the key problem of knowledge: Since technical details matter, conclusions must be taken by non-economists on faith in economists’ expertise, by watching the development of a near-consensus of economists, and by consonance with observers’ overall world-view. But because political and moral commitments shape how we economists view the evidence, we economists will never reach conclusions with a near-consensus – even putting to one side those economists who trim their sails out of an unwarranted and excessive lust for high federal office. And note that neither Carmen Reinhart nor Kenneth Rogoff have such a lust.

We do not live in the Republic of Plato. We live in the Sewer of Romulus. In this fallen sublunary sphere, the gap between what economists should do and be and what they actually are and do is distressingly large, and uncloseable.

And this leaves you–those of you who must listen to we economists when we speak as public intellectuals in the public square–with a substantial problem.

V. Should You Pay Attention to Economists as Public Intellectuals in the Public Square?

You have to.

You have no choice.

You all have to listen.

But you have nearly no ability to evaluate what you hear. When we don’t reach a near-consensus, then Heaven help you. Unless you are willing make me intellectual dictator and philosopher-king, I cannot.

Sluggish Future: No Longer Fresh Over at Finance and Development

Posted on by Brad DeLong
Secular Stagnation

Over at Finance and Development: Sluggish Future: You are reading this because of the long, steady decline in nominal and real interest rates on all kinds of safe investments, such as US Treasury securities. The decline has created a world in which, as economist Alvin Hansen put it when he saw a similar situation in 1938, we see “sick recoveries… die in their infancy and depressions… feed on themselves and leave a hard and seemingly immovable core of unemployment…” In other words, a world of secular stagnation. Harvard Professor Kenneth Rogoff thinks this is a passing phase—that nobody will talk about secular stagnation in nine years. Perhaps. But the balance of probabilities is the other way. Financial markets do not expect this problem to go away for at least a generation… Read MOAR at Finance and Development

My Draft: You are reading this right now because of the long, steady decline in safe interest rates at all maturities since 1990.(1)

In the United States, we have seen declines in short-term safe interest rates from 4% to -1.2% on the real side and from 8% to 0.5% on the nominal side. And we have seen the decline in long-term safe interest rates from 5% to 1% on the real side, and from 9% to 3% on the nominal side. The elusive Wicksellian “neutral” rate of interest—that rate at which planned investment equals desired full-employment savings—has fallen by more: the economy in 1990 had no pronounced tendency to fall short of full employment; the economy today has.

An economy suffers from “secular stagnation” when the average level of safe nominal interest rates is low and so crashes the economy into the zero lower bound with frequency. Thus, in the words of Alvin Hansen (1939): “sick recoveries… die in their infancy and depressions… feed on themselves and leave a hard and seemingly immovable core of unemployment…”(2)

Financial markets, at least, do not expect this problem to go away for at least as generation. That makes, as I have written, this current policy debate “the most important policy-relevant debate in economics since John Maynard Keynes’s debate with himself in the 1930s…”

I have heard eight different possible causes advanced for this secular fall in safe interest rates:

  1. High income inequality, which boosts savings too much because the rich can’t think of other things they’d rather do with their money.
  2. Technological and demographic stagnation that lowers the return on investment and pushes desired investment spending down too far.
  3. Non-market actors whose strong demand for safe, liquid assets is driven not by assessments of market risk and return but rather by political factors or by political risk.
  4. A collapse or risk-bearing capacity as a broken financial sector finds itself overleveraged and failing to mobilize savings, thus driving a large wedge between the returns on risky investments and the returns on safe government debt.
  5. Very low actual and expected inflation, which means that even a zero safe nominal rate of interest is too high to balance desired investment and planned savings at full employment.
  6. Limits on the demand for investment goods coupled with rapid declines in the prices of those goods, which together put too much downward pressure on the potential profitability of the investment-goods sector.
  7. Technological inappropriateness, in which markets cannot figure out how to properly reward those who invest in new technologies even when the technologies have enormous social returns—which in turn lowers the private rate of return on investment and pushes desired investment spending down too far.
  8. Increased technology- and rent seeking-driven obstacles to competition which make investment unprofitable for entrants and market-cannibalizing for incumbents.

The first of these was John A. Hobson’s explanation a century ago for the economic distress that had led to the rise of imperialism.(3) The second was, of course, Hansen’s, echoed today by Robert Gordon.(4) The third is Ben Bernanke’s global savings glut.(5) The fourth is Ken Rogoff’s debt-supercycle.(6)

The fifth notes that, while safe real interest rates are higher than they were in the 1980s and 1990s, that is not the case for the 1960s and 1970s. It thus attributes the problem to central banks’ inability to generate the boost from expected and actual inflation a full-employment flex-price economy would generate naturally.(7)

(6), (7), and (8) have always seemed to me to be equally plausible as potential additional factors. But the lack of communication between industrial organization and monetary economics has deprived them of scrutiny. While Gordon, Bernanke, Rogoff, Krugman, and many others have covered (1) through (5), (6), (7), and (8) remain undertheorized.

In general, economists have focused on a single individual one of these causes, and either advocated policies to cure it at its roots or waiting until the evolution of the market and the polity removes it. By contrast, Lawrence Summers(8) has focused on the common outcome. And if one seeks not to cure a single root cause but rather to neutralize and palliate the deleterious macroeconomic effects of a number of causes working together, one is driven—as Larry has been—back to John Maynard Keynes (1936)(9):

A somewhat comprehensive socialisation of investment… [seems] the only means of securing an approximation to full employment… not exclud[ing] all manner of compromises and of devices by which public authority will cooperate with private initiative…

Summers has, I think, a very strong case here. Ken Rogoff likes to say that nine years from now nobody will be talking about secular stagnation.

Perhaps.

But if that is so, it will most likely be so because we will have done something about it.

 

Notes:

(1) For considerably overlapping and much extended versions of this argument, see J. Bradford DeLong (2016): Three, Four… Many Secular Stagnations! http://www.bradford-delong.com/2017/01/three-four-many-secular-stagnations.html; (2015): The Scary Debate Over Secular Stagnation: Hiccup… or Endgame? Milken Review http://tinyurl.com/dl20170106m

(2) Alvin Hansen (1939): Economic Progress and Declining Population Growth American Economic Review https://www.jstor.org/stable/1806983

(3) John A. Hobson (1902): Imperialism: A Study (New York: James Pott) http://files.libertyfund.org/files/127/0052_Bk.pdf

(4) Robert Gordon (2016): The Rise and Fall of American Growth http://amzn.to/2iVbYKm

(5) Ben Bernanke (2005): The Global Saving Glut and the U.S. Current Account Deficit http://www.federalreserve.gov/boarddocs/speeches/2005/200503102/

(6) Kenneth Rogoff (2015): Debt Supercycle, Not Secular Stagnation http://www.voxeu.org/article/debt-supercycle-not-secular-stagnation

(7) Paul Krugman (1998): The Return of Depression Economics http://tinyurl.com/dl20170106r

(8) Lawrence Summers (2013): Secular Stagnation http://larrysummers.com/imf-fourteenth-annual-research-conference-in-honor-of-stanley-fischer/ ; https://www.youtube.com/watch?v=KYpVzBbQIX0&ab_channel=JamesDecker; (2014): U.S. Economic Prospects: Secular Stagnation, Hysteresis, and the Zero Lower Bound http://link.springer.com/article/10.1057%2Fbe.2014.13; (2015): Rethinking Secular Stagnation After Seventeen Months http://larrysummers.com/wp-content/uploads/2015/07/IMF_Rethinking-Macro_Down-in-the-Trenches-April-20151.pdf;(2016): The Age of Secular Stagnation http://larrysummers.com/2016/02/17/the-age-of-secular-stagnation/

(9) John Maynard Keynes (1936): The General Theory of Employment, Interest and Money https://www.marxists.org/reference/subject/economics/keynes/general-theory/ch24.htm

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The Need for a Reformation of Authority and Hierarchy Among Economists in the Public Sphere

Posted on by Brad DeLong

I find that I have much more to say (or, rather, largely, republish), relevant to the current debate between Simon Wren-Lewis and Unlearning Economics.

Let me start by saying that I think Unlearning Economics is almost entirely wrong in his proposed solutions.

Indeed, they does not seem especially knowledgeable about their cases. For example:

  1. the trashing of the Grameen Bank is undeserved;

  2. the blanket denunciation of RCTs as having “benefited global and local elites at the expensive of the poorest” is just bonkers;

  3. Merton and Scholes’s financial math was correct, and the crash of their hedge fund did not require any public-money bailout;

  4. Janine Wedel is not a reliable source on Russian privatization, which I saw and see as the only practical chance to try to head off the oligarchic plutocracy that has grown up in Russia under Yeltsin and Putin (and, no, my freshman roommate Andrei was not prosecuted for “fraud in Russia”, but rather the Boston U.S. Attorney’s office overreached and was unwilling to admit it);

  5. Unlearning Economics confuses the more-sinister Friedrich von Hayek (who welcomed Pinochet’s political “excesses” as a necessary Lykurgan moment) with the truly-libertarian Milton Friedman, who throughout his whole life was dedicated to not telling people what to do, and who saw Pinochet as another oppressive authoritarian who might be induced to choose better rather than worse economic policies;

  6. and then there is Reinhart and Rogoff, where I think Unlearning Economics is right.

So Unlearning Economics is batting 0.170 in their examples of “mainstream economics considered harmful”. But there is that one case. And I do not think that Simon Wren-Lewis handles that one case well. And he needs to–I need to. And, since neither he nor I have, this is a big problem.

Let me put it this way: Carmen Reinhart and Ken Rogoff are mainstream economists.

The fact is that Carmen Reinhart and Ken Rogoff were wrong in 2009-2013. Yet they had much more influence on economic policy in 2009-2013 than did Simon Wren-Lewis and me. They had influence. And their influence was aggressively pro-austerity. And their influence almost entirely destructive.

Simon needs to face that fact squarely, rather than to dodge it. The fact is that the “mainstream economists, and most mainstream economists” who were heard in the public sphere were not against austerity, but rather split, with, if anything, louder and larger voices on the pro-austerity side. (IMHO, Simon Wren-Lewis half admits this with his denunciations of “City economists”.) When Unlearning Economics seeks the destruction of “mainstream economics”, he seeks the end of an intellectual hegemony that gives Reinhart and Rogoff’s very shaky arguments a much more powerful institutional intellectual voice by virtue of their authors’ tenured posts at Harvard than the arguments in fact deserve. Simon Wren-Lewis, in response, wants to claim that strengthening the “mainstream” would somehow diminish the influence of future Reinharts and Rogoffs in analogous situations. But the arguments for austerity that turned out to be powerful and persuasive in the public sphere came from inside the house!

Simon Wren-Lewis: On Criticising the Existence of Mainstream Economics: “I’m very grateful to Unlearning Economics (UE) for writing in a clear and forceful way a defence of the idea that attacking mainstream economics is a progressive endeavor…

…I think such attacks are far from progressive…. Devoting a lot of time to exposing students to contrasting economic frameworks (feminist, Austrian, post-Keynesian)… means cutting time spent on learning the essential tools that any economist needs…. Let me start at the end of the UE piece:

The case against austerity does not depend on whether it is ‘good economics’, but on its human impact. Nor does the case for combating climate change depend on the present discounted value of future costs to GDP. Reclaiming political debate from the grip of economics will make the human side of politics more central, and so can only serve a progressive purpose…

Austerity did not arise because people forgot about its human impact. It arose because politicians, with help from City economists, started scare mongering about the deficit…. Every UK household knew that your income largely dictates what you can spend, and as long as the analogy between that and austerity remained unchallenged, talk about human impact would have little effect…. The only way to beat austerity is to question the economics on which it is based…. Having mainstream economics, and most mainstream economists, on your side in the debate on austerity is surely a big advantage….

Where UE is on stronger ground is where they question the responsibility of economists…. Politicians grabbed hold of the Rogoff and Reinhart argument about a 90% threshold for government debt:

Where was the formal, institutional denunciation of such a glaring error from the economics profession, and of the politicians who used it to justify their regressive policies? Why are R & R still allowed to comment on the matter with even an ounce of credibility? The case for austerity undoubtedly didn’t hinge on this research alone, but imagine if a politician cited faulty medical research to approve their policies—would institutions like the BMA not feel a responsibility to condemn it?”

I want to avoid getting bogged down in the specifics of this example, but instead just talk about generalities…. If some professional body started ruling on what the consensus among economists was… [that] would go in completely the opposite direction from what most heterodox economists wish…. There is plenty wrong with mainstream economics, but replacing it with schools of thought is not the progressive endeavor that some believe. It would just give you more idiotic policies like Brexit.

What did Reinhart and Rogoff say? What Let me turn the mike over to Tom Cotton:

Reinhart and Rogoff had… dismantl[ed] the mistaken belief… that this particular group of [Democratic] policymakers in this moment in history was somehow smarter than all the others and could run up debt forever without catastrophic consequences…. They wrote:

We have been here before. No matter how different the latest financial frenzy or crisis always appears, there are usually remarkable similarities with past experience from other countries and from history. Recognizing these analogies and precedents is an essential step toward improving our global financial system, both to reduce the risk of future crisis and to better handle catastrophes when they happen…

The student senators began asking questions with a sincere curiosity cynics would find disarming. Johnny Isakson, a Republican from Georgia and always a gentleman, stood up to ask his question: “Do we need to act this year? Is it better to act quickly?” “Absolutely,” Rogoff said: “Not acting moves the risk closer,” he explained, because every year of not acting adds another year of debt accumulation. “You have very few levers at this point….” Neither Reinhart nor Rogoff said we could fix our debt problem with just tax increases. Both emphasized the need for comprehensive tax reform and tax code simplification…. “I don’t want to be fire and brimstone,” Rogoff said. “No one knows when this will happen.” Yet, he added, “It takes more than two years to turn the ship around…. Once you’ve waited too long, it’s too hard to take radical steps”…

Plus there are things like Rogoff’s:

Debt levels of 90% of GDP are a long-term secular drag on economic growth that often lasts for two decades or more…. There is two-way feedback between debt and growth, but normal recessions last only a year and cannot explain a two-decade period of malaise. The drag on growth is more likely to come from the eventual need for the government to raise taxes, as well as from lower investment spending. So, yes, government spending provides a short-term boost, but there is a trade-off with long-run secular decline…

Simon Wren-Lewis wants to say:

  • mainstream economists good
  • City economists bad
  • Feminist, Austrian, post-Keynesian economists unhelpful because they distract focus from the powerful mainstream arguments that austerity is bad.

And the problem is that Carmen Reinhart and Ken Rogoff are not “City” but mainstream economists—as are Martin Feldstein, John Taylor, Greg Mankiw, Glenn Hubbard, Eugene Fame, Robert Lucas, Robert Barro, and a huge host of others pro-austerity throughout 2008-2017. That is the elephant in the room that Simon needs to face. And when he writes that he wants to “avoid getting bogged down in the specifics of this example”, he evades UE’s big question and fails to make the argument he needs to make.

Background:

Why Are Reinhart and Rogoff—and Other Mainstream Economists—so Wrong?

On a psychological level—for an explanation of why they said and wrote what they said and wrote—I have no explanation. On the technocratic level, there is a lot to say:

When Carmen Reinhart and Kenneth Rogoff wrote their “Growth in a Time of Debt”, they asked the question:

Outsized deficits and epic bank bailouts may be useful in fighting a downturn, but what is the long run macroeconomic impact or higher levels of government debt, especially against the backdrop of graying populations and rising social insurance costs?

They concluded that over the past 200 years:

[T]he relationship between government debt and real GDP growth is weak for debt/GDP ratios below a threshold of 90 percent of [annual] GDP. Above 90 percent, median growth rates fall by one percent, and average growth… more… in [both] advanced and emerging economies…. [In] emerging markets… [w]hen external debt reaches 60 percent of GDP, annual growth declines by about two percent…. [T]here is no apparent contemporaneous link between inflation and public debt levels for the advanced countries…. The story is entirely different for emerging markets, where inflation rises sharply as debt increases.

And the graph that caught the world’s imagination was:

NewImage

The principal mistake Reinhart and Rogoff committed in their analysis and paper–indeed, the only significant mistake in the paper itself–was their use of the word “threshold”.

It and the graph led very many astray.

For example, it led the almost-always-unreliable Washington Post editorial board to condemn the:

new school of thought about the deficit…. ‘Don’t worry, be happy. We’ve made a lot of progress’, says an array of liberal pundits… [including] Martin Wolf of the Financial Times… their analysis assumes steady economic growth and no war. If that’s even slightly off, debt-to-GDP could… stick dangerously near the 90 percent mark that economists regard as a threat to sustainable economic growth…

(Admittedly, experience since the start of the millennium gives abundant evidence that the Washington Post needs no empirical backup from anybody in order to lie and mislead in whatever way the wind blows.)

It misled European Commissioner Olli Rehn to claim that:

When [government] debt reaches 80-90% of GDP, it starts to crowd out activity in the private sector and other parts of the economy…

Both of these–and a host of others–think that if debt-to-annual-GDP is less than 90% (or, in Rehn’s case, 80%, and I have no idea where the 80% comes from) an economy is safe, and that only if it is above 90% is the economy’s growth in danger. And in their enthusiasm when they entered congressional briefing mode it led Reinhart and Rogoff themselves astray.

Yet the threshold at 90% is not there. In no sense is there empirical evidence that a 90% ratio of debt-to-annual-GDP is in any sense an “important marker”, a red line. That it appears to be in Reinhart and Rogoff’s paper is an artifact of Reinhart and Rogoff’s non-parametric method: throw the data into four bins, with 90% the bottom of the top bin. There is, instead, a gradual and smooth decline in growth rates as debt-to-annual-GDP increases. 80% looks only trivially different than 100%.
Owen Zidar provides what seems to me at least to be a much more informative cut at the data:

NewImage

and he writes:

I took all countries with Public Debt to GDP ratios above 50… evenly divided them into 50 equalized sized bins of Debt to GDP… plot the mean of the outcome of interest for each bin…. [This] would show clean breaks at a Debt to GDP ratio of 90 if they actually exist…

There is no 90% threshold. Making policy under the belief that risks at 100% are very different than risks at 80% is in no way supported by any of the data.

Moreover, there is the big question of how much of this decline in growth as debt rises is cause for fear? Correlation, after all, is only sometimes causation. Ken Rogoff claims that this is one of those cases. Is he write?

First, a good deal of this high-debt-to-GDP growth-decline correlation comes from countries where interest rates tend to be higher and the stock market tends to be lower where government debt is higher. That is simply not relevant to the U.S. today.

Second, a good deal of this correlation comes from countries where inflation rates are higher when government debt is higher. That is not relevant to the U.S. today.

Third, a good deal more of this correlation comes from countries where growth was already slow, and high government debt relative to GDP is, as Larry Summers constantly says, a result not of the numerator but of previous trends in the denominator. That is not relevant to the U.S. today.

How much of this correlation is left for a country with low interest rates, low inflation rates, buoyant stock prices, and healthy prior growth? We need to know that before we can even begin to analyze causation.

And the answer is: not much, if any. Until interest and inflation rates begin to rise above normal levels or the stock market tanks, there is little risk to accumulating more government debt here in the United States. And there are large potential benefits from solving our real low employment and slack capacity problems right now

What did I mean by “not much”? Let me highlight a passage from the “Understanding Our Adversaries” evolution-of-economists’-views talk that I have been giving for several months now, a passage based on work by Owen Zidar summarized by the graph above:

The argument [for fiscal contraction and against fiscal expansion in the short run] is now: never mind why, the costs of debt accumulation are very high. This is the argument made by Reinhart, Reinhart, and Rogoff: when your debt to annual GDP ratio rises above 90%, your growth tends to be slow. This is the most live argument today. So let me nibble away at it:

  1. Note well: no cliff at 90%.

  2. RRR present a correlation–not a causal mechanism, and not a properly-instrumented regression. There argument is a claim that high debt-to-GDP and slow subsequent growth go together, without answering the question of which way causation runs. Let us answer that question. And the answer is that the bulk of causation is not there, and provides no reason for the U.S. to fear.

  3. Note is how small the correlation is.

Suppose that all of the correlation is causation from higher debt to slower growth. Let us then consider two cases: a multiplier of 1.5 and a multiplier of 2.5, both with a marginal tax share of 1/3. Suppose the growth-depressing effect lasts for 10 years. And suppose that we boost government spending by 2% of GDP.

Let us boost government spending for this year only in the first case. Output this year then goes up by 3% of GDP. Debt goes up by 1% of GDP taking account of higher tax collections. This higher debt then reduces growth by… wait for it… 0.006% points per year. After 10 years GDP is lower than it would otherwise have been by 0.06%. 3% higher GDP this year and slower growth that leads to GDP lower by 0.06% in a decade. And this is supposed to be an argument against expansionary fiscal policy right now?

The 2.5 multiplier case is more so. Spend an extra 2% of GDP over each of the next three years. Collect 15% of a year’s extra output as a plus in the short run. Taking account of higher tax revenues, debt goes up by 1% of GDP, and we have the same ten-year depressing effect of 0.06% of GDP.

15% now. -0.06% in a decade.

The first would be temporary, the second is permanent, but even so the costs are much less than the benefits as long as the economy is still at the zero lower bound.

And this isn’t the graph that you were looking for. You want the causal graph. That, worldwide, growth is slow for other reasons when debt is high for other reasons or where debt is high for other reasons is in this graph, and should not be. Control for country and era effects and Owen reports that the -0.06% becomes -0.03%. As Larry Summers never tires of pointing out, (a) debt-to-annual-GDP ratio has a numerator and a denominator, and (b) sometimes high-debt comes with high interest rates and we expect that to slow growth but that is not relevant to the North Atlantic right now. If the ratio is high because of the denominator, causation is already running the other way. We want to focus on cases of high debt and low interest rates. Do those two things and we are down to a -0.01% coefficient.

We are supposed to be scared of a government-spending program of between 2% and 6% of a year’s GDP because we see a causal mechanism at work that would also lower GDP in a decade by 0.01% of GDP?

That does not seem to me to compute.

As a very smart old Washington hand wrote me:

True, but the 90% red line seemed to say there is nothing more important than moving debt down relative to GDP (though Ken and Carmen would probably acknowledge that faster growth, say through some even more forceful unconventional monetary policy, was a legitimate means to do that).

And why not add more? From my Notre Dame Paper:

IV. We Dwell Not in the Republic of Plato But in the Sewer of Romulus

In the last days before the coming of the Roman Empire, Marcus Tullius Cicero in Rome wrote to his best correspondent Titus Pomponius Atticus in Athens:

You cannot love our dear [Marcus Porcius] Cato any more than I do; but the man – although employing the finest mind and possessing the greatest trustworthiness – sometimes harms the Republic. He speaks as if we were in the Republic of Plato, and not in the sewer of Romulus…

Whatever you may think about economists’ desires to use their technical and technocratic expertise to reduce the influence of both the Trotskys and the St. Benedicts in the public square, there is the prior question of whether here and now – in this fallen sublunary sphere, among the filth of Romulus – they have and deploy any proper technical and technocratic expertise at all. And we seem to gain a new example of this every week.

The most salient relatively-recent example was provided by Carmen Reinhart and Kenneth Rogoff[39][39] – brilliant, hard-working economists both, from whom I have learned immense amounts. Rogoff’s depth of thought and breadth of knowledge about how countries act and how economies respond in the arena of the international monetary system is a global treasure. Reinhart’s breadth and depth of knowledge about how governments have issued, financed, amortized, paid off, or not paid off their debts over the past two centuries is the greatest in the world.

Debt to GDP Ratio and Future Economic Growth pdf page 5 of 6

However, they believed that the best path forward for the developed economies – the U.S., Germany, Britain, and Japan – was for them to shrink their government deficits quickly and quickly halt the accumulation of and begin to pay down government debt. My faction, by contrast, believed that the best path forward for these economies was for them to expand their government deficits now and let the debt grow until either economies recover to normal levels of employment or until interest rates begin to rise significantly.

Why does my faction disagree with them? Let me, first, rely on the graph above that is the product of work by Berkeley graduate student Owen Zidar, plotting how economic growth in different industrialized countries in different eras has varied along with the amount of government debt that they had previously accumulated. And let me give the explanation of why I disagree with Reinhart and Rogoff that I was giving at seminars around the country in the early 2010s:

The argument [for fiscal contraction and against fiscal expansion in the short run] is now: never mind why, the costs of debt accumulation are very high. This is the argument made by Reinhart and Rogoff: when your debt to annual GDP ratio rises above 90%, your growth tends to be slow.

This is the most live argument today. So let me nibble away at it. And let me start by presenting the RRR case in the form of Owen Zidar’s graph.

First: note well: no cliff at 90%.

Second, RRR present a correlation – not a causal mechanism, and not a properly-instrumented regression. Their argument is a claim that high debt-to-GDP and slow subsequent growth go together, without answering the question of which way causation runs. Let us answer that question.

The third thing to note is how small the correlation is. Suppose that we consider two cases: a multiplier of 1.5 and a multiplier of 2.5, both with a marginal tax share of 1/3. Suppose the growth-depressing effect lasts for 10 years. Suppose that all of the correlation is causation running from high debt to slower future growth. And suppose that we boost government spending by 2% of GDP this year in the first case. Output this year then goes up by 3% of GDP. Debt goes up by 1% of GDP taking account of higher tax collections. This higher debt then reduces growth by… wait for it… 0.006% points per year. After 10 years GDP is lower than it would otherwise have been by 0.06%. 3% higher GDP this year and slower growth that leads to GDP lower by 0.06% in a decade. And this is supposed to be an argument against expansionary fiscal policy right now?

The 2.5 multiplier case is more so. Spend 2% of GDP over each of the next three years. Collect 15% of a year’s extra output in the short run. Taking account of higher tax revenues, debt goes up by 1% of GDP and we have the same ten-year depressing effect of 0.06% of GDP. 15% now. -0.06% in a decade. The first would be temporary, the second is permanent, but even so the costs are much less than the benefits as long as the economy is still at the zero lower bound.

And this isn’t the graph that you were looking for. You want the causal graph. That, worldwide, growth is slow for other reasons when debt is high for other reasons or where debt is high for other reasons is in this graph, and should not be. Control for country and era effects and Owen reports that the -0.06% becomes -0.03%. As Larry Summers never tires of pointing out, (a) debt-to-annual-GDP ratio has a numerator and a denominator, and (b) sometimes high-debt comes with high interest rates and we expect that to slow growth but that is not relevant to the North Atlantic right now. If the ratio is high because of the denominator, causation is already running the other way. We want to focus on cases of high debt and low interest rates. Do those two things and we are down to a -0.01% coefficient.

We are supposed to be scared of a government-spending program of between 2% and 6% of a year’s GDP because we see a causal mechanism at work that would also lower GDP in a decade by 0.01% of GDP? That does not seem to me to compute.

Now I have been nibbling the RRR result down. Presumably they are trying to see if it can legitimately be pushed up. This will be interesting to watch over the next several years, because RRR is the heart of the pro-austerity case right now.

That ends what I would typically try to say.

And that is as concise and simple an explanation of why I disagree with Reinhart and Rogoff as I can give.

If you are not a professional economist and have managed to understand that, I salute you.

They disagree with me, first, they started with different prior beliefs – different assumptions about the relative weight to be given to different scenarios and the relative risks of different courses of action that lead them to read the evidence differently. Second, they made some data processing errors – although those are a relatively minor component of our differences – and are now dug in, anchored to the positions they originally took, and rationalizing that the data processing errors do not change the qualitative shape of the picture. Third, they have made different weighting decisions as to how to handle the data. Is Owen Zidar putting his thumb on the scales, and weighting the data because he knows that the effects of high debt in reducing growth are small? I don’t think so: his weighting scheme is simple, and he is too young to be dug in and have a dog in this fight. But I am, perhaps, not the best judge.

But when we venture out of data collection and statistics and the academy into policy advocacy in the public square the differences become very large indeed. Matthew O’Brien quotes Senator Tom Coburn’s report on Reinhart and Rogoff’s briefing of the Republican Congressional Caucus in April 2011:

Johnny Isakson, a Republican from Georgia and always a gentleman, stood up to ask his question: “Do we need to act this year? Is it better to act quickly?”

“Absolutely,” Rogoff said. “Not acting moves the risk closer,” he explained, because every year of not acting adds another year of debt accumulation. “You have very few levers at this point,” he warned us.

Reinhart echoed Conrad’s point and explained that countries rarely pass the 90 percent debt-to-GDP tipping point precisely because it is dangerous to let that much debt accumulate. She said, “If it is not risky to hit the 90 percent threshold, we would expect a higher incidence.”

I think we have by far the better of the argument. Yet it is very clear that even today Reinhart and Rogoff – and allied points by economists like Alberto Alesina, Francesco Giavazzi, et al., where I also think we have the better of the argument by far – have had a much greater impact on the public debate than my side has.

Thus, the key problem of knowledge: Since technical details matter, conclusions must be taken by non-economists on faith in economists’ expertise, by watching the development of a near-consensus of economists, and by consonance with observers’ overall world-view. But because political and moral commitments shape how we economists view the evidence, we economists will never reach conclusions with a near-consensus – even putting to one side those economists who trim their sails out of an unwarranted and excessive lust for high federal office. And note that neither Carmen Reinhart nor Kenneth Rogoff have such a lust.

We do not live in the Republic of Plato. We live in the Sewer of Romulus. In this fallen sublunary sphere, the gap between what economists should do and be and what they actually are and do is distressingly large, and uncloseable.

And this leaves you – those of you who must listen to we economists when we speak as public intellectuals in the public square – with a substantial problem.

V. Should You Pay Attention to Economists as Public Intellectuals in the Public Square?

You have to.

You have no choice.

You all have to listen.

But you have nearly no ability to evaluate what you hear. When we don’t reach a near-consensus, then Heaven help you. Unless you are willing make me intellectual dictator and philosopher-king, I cannot.