Wednesday, July 23, 2014

DSGE Failing the Market Test?

The prevailing methodology of macroeconomic theory these days is "Dynamic Stochastic General Equilibrium" (DSGE) modelling.  Although many contemporary DSGE models, including the ones I'm working on, include "Keynesian" elements such as sticky prices, unemployment and financial frictions, they represent a methodological break with an older style of "Keynesian" models based on relationships among aggregate variables.  The shift in method followed from the work of Lucas and Sargent (most prominently among others) -- which John Cochrane summarized on his blog:
As I see it, the main characteristic of "equilibrium" models Lucas and Sargent inaugurated is that they put people, time, and economics into macro.

Keynesian models model aggregates. Consumption depends on income. Investment depends on interest rates. Labor supply and demand depend on wages. Money demand depends on income and interest rates. "Consumption" and "investment" and so forth are the fundamental objects to be modeled.

"Equilibrium" models (using Lucas and Sargent's word) model people and technology. People make simultaneous decisions across multiple goods, constrained by budget constraints -- if you consume more and save more, you must work more, or hold less money.  Firms  make decisions across multiple goods constrained by technology.

Putting people and their simultaneous decisions back to the center of the model generates Lucas and Sargent's main econometric conclusion -- Sims' "incredible" identifying restrictions. When people simultaneously decide consumption, saving, labor supply, then the variables describing each must spill over in to the other. There is no reason for leaving (say) wages out of the consumption equation. But the only thing distinguishing one equation from another is which variables get left out.

People make decisions thinking about the future. I think "static" vs. "intertemporal" are good words to use.  That observation goes back to Friedman: consumption depends on permanent income, including expected future income, not today's income. Decisions today are inevitably tied to expectations --rational or not -- about the future.
A Bloomberg View column by Noah Smith nicely summarizes the methodological shift, which gained momentum from the apparent breakdown of the Phillips curve relationship between inflation and unemployment in the 1970s.  Smith writes:
Lucas showed that trying to boost gross domestic product by raising inflation might be like the tail trying to wag the dog. To avoid that kind of mistake, he and his compatriots declared, macroeconomists needed to base their models on things that wouldn’t change when government policy changed -- things like technology, or consumer preferences. And so DSGE was born. (DSGE also gave macroeconomists a chance to use a lot of cool new math tricks, which probably increased its appeal.)

OK, history lesson over. So why is this important now?

Well, for one thing, the finance industry has ignored DSGE models. That could be a big mistake! Suppose you’re a macro investor. If all you want to do is make unconditional forecasts -- say, GDP next quarter – then you can go ahead and use an old-style SEM model, because you only care about correlation, not causation. But suppose you want to make a forecast of the effect of a government policy change -- for example, suppose you want to know how the Fed’s taper will affect growth. In that case, you need to understand causation -- you need to know whether quantitative easing is actually changing people’s behavior in a predictable way, and how.

This is what DSGE models are supposed to do. This is why academic macroeconomists use these models. So why doesn’t anyone in the finance industry use them? Maybe industry is just slow to catch on. But with so many billions upon billions of dollars on the line, and so many DSGE models to choose from, you would think someone at some big bank or macro hedge fund somewhere would be running a DSGE model. And yet after asking around pretty extensively, I can’t find anybody who is.
That's an interesting question -- when thinking about issues like this, I often come back to the divide between "science" and "engineering" put forward by Greg Mankiw.  While academic macroeconomics has gone down the path marked out Lucas and Sargent, the policymaking "engineers" in Washington often still find the older-style models more useful.  It sounds like Wall Street's economists do too. 

The question is whether academic macroeconomics is on track to produce models that are more useful for the policymakers and moneymakers. The DSGE method is still fairly new, and, until recently, we've been constrained by the limitations of our computers as well as our minds (a point Narayana Kocherlakota made here), so maybe we're just not quite there yet.  But we should be open to the possibility that we're on the wrong track entirely.

Saturday, July 5, 2014

Efficiency Wages

The New York Times has a story about several restaurants that have decided to pay above-market wages.  One of them is Shake Shack, which is starting employees at $9.50/hr:
“The No. 1 reason we pay our team well above the minimum wage is because we believe that if we take care of the team, they will take care of our customers,” said Randy Garutti, the chief executive of Shake Shack.
That, and other anecdotes in the article, are consistent with the "efficiency wage" theory, where firms can induce more effort by paying a higher real wage.  This might arise if firms have a less than perfect ability to monitor individual employees' productivity - paying an above-market wage creates a stronger incentive not to "shirk". 

For more, see this brief 1984 survey by Janet Yellen, who did some of her early academic work in this area.

Tuesday, July 1, 2014

Classroom Technology

Despite evidence that having computers in class is not good for students, Slate's Rebecca Schumann argues that professors should permit them anyway:
[P]olicing the (otherwise nondisruptive) behavior of students further infantilizes these 18-to-22-year-olds. Already these students are hand-held through so many steps in the academic process: I check homework; I give quizzes about the syllabus to make sure they’ve actually read it; I walk them, baby-steps style, through every miniscule stage of their essays. Some of these practices do indeed improve what contemporary pedagogy parlance calls “learning outcomes” (barf) because they show students how invested I am in their progress. But these practices also serve as giant, scholastic water wings for people who should really be swimming by now.

My colleagues and I joke sometimes that we teach “13th-graders,” but really, if I confiscate laptops at the door, am I not creating a 13th-grade classroom? Despite their bottle-rocket butt pranks and their 10-foot beer bongs, college students are old enough to vote and go to war. They should be old enough to decide for themselves whether they want to pay attention in class—and to face the consequences if they do not.
I'm sympathetic to the argument - I've never had an "attendance policy" for essentially the same reason - but what Schumann misses is that the use of laptops have a negative spillover effect (what economists call an "externality").  A student who is using a computer will not only distract herself but also the students around her - it is the harm to others, and the classroom environment more generally, that justifies prohibiting computers in class.

Schumann goes on to argue the real problem is lecture format classes.  I don't think its appropriate to generalize - the optimal format probably varies across subjects (and across students, too, which may be a more difficult problem).  I'm planning some pretty big changes to the way I teach my classes for the coming year that will significantly reduce the amount of lecturing I do.  I wouldn't be doing this if I didn't expect the benefits to outweigh the costs, but I suspect the virtues of the traditional lecture style may be under-appreciated these days.  In particular, the act of note-taking by hand is a valuable part of the learning process.  A recent NY Times story about the decline of handwriting instruction in schools discussed some evidence on that point:
Two psychologists, Pam A. Mueller of Princeton and Daniel M. Oppenheimer of the University of California, Los Angeles, have reported that in both laboratory settings and real-world classrooms, students learn better when they take notes by hand than when they type on a keyboard. Contrary to earlier studies attributing the difference to the distracting effects of computers, the new research suggests that writing by hand allows the student to process a lecture’s contents and reframe it — a process of reflection and manipulation that can lead to better understanding and memory encoding.
Although we should always be looking for ways to improve, and to take advantage of new technology where it can be helpful, sometimes "innovation" carries hidden costs, and we will make better choices if we try to understand what those might be and take them into account.

Thursday, June 26, 2014

Not Repeating All of Our Mistakes

With all the frustrations and mistakes of the recent years, its easy to miss the good economic policy news, but there is some --

At Wonkblog, Lydia DePillis reports on the lack of a turn towards protectionism on the part of high-income countries during the global slump of the last few years.  The evidence she cites suggests that developing countries have raised trade barriers, but in a fairly muted fashion.

That's a huge improvement over the 1930s which saw widespread increases in trade barriers (including US' infamous Smoot-Hawley tariff).  Though the increases in tariffs and other trade barriers did not cause the depression, most of us economists regard them as a counter-productive response.

The architecture of the GATT and WTO was developed in part to prevent making the same mistake again.  However, the rules do allow for temporary increases in tariffs through "antidumping", "safeguard" and "countervailing duty" measures, but there hasn't been a large increase in the use of these measures. DePillis writes:
So, why did the United States appear to be less aggressive about protecting itself in the face of the latest economic meltdown? It's learned from experience.

"We designed the current system in response to what happened in the 1930s," says Chad Bown, a World Bank economist who maintains the database of temporary trade barriers. For one thing, the United States is able to target products more specifically rather than entire sectors. "That helps blow off some political steam and not have overall increases in protection," Bown says.
Another important factor may be that now, unlike the 1930s, the world is largely operating under a (non) system of floating currencies. In Trade Policy Disaster, Doug Irwin argues (persuasively, I think) that the motivation for the increasing trade barriers was more "mercantilist" than "protectionist" - that governments were concerned with preventing trade deficits, which would have led to deflationary gold outflows under the gold standard.  

Today's countries aren't bound the same way.  The one exception is Europe, where the economies of "peripheral" Europe are the hardest-suffering in the world - they can't adjust through depreciation, and the EU prevents Spain and Greece from raising tariffs.

Update: At VoxEU, Chad Bown discusses some findings from the Temporary Trade Barriers Database.

GDP in the Rear-View Mirror

appears smaller than it did before --  the BEA's "third estimate" of real GDP growth came in at -2.9% annual rate.  That's really bad, and a big revision from the "advance estimate" in April of 0.1% growth, and the "second estimate" in May of -1%.
One of the things I emphasize to my students are the limitations of GDP statistics.  One of the difficulties in using them is that they are subject to substantial revisions, that come in with considerable lags.  Policymakers - and anyone else trying to judge the state of the economy - are looking at noisy, backward-looking data. 

Here it is, just past the summer solstice, that we learn that GDP last winter (Jan. - Mar.) was dropping at its fastest rate since 2009 (the first quarter of 2011 is only one other quarter since the recession with declining GDP).  The rate of decline in the 1st quarter was worse than either of the two quarters with negative growth in the 2001 recession.

Although there are usually some changes, this particular revision was unusually large - the change from the initial to the third estimate was the largest since the BEA began releasing estimates this way in the mid-1980's.

The prevailing theory on why the first-quarter was so bad appears to be that it was mainly due to unusually severe weather; although the data are "seasonally adjusted" to account for the fact that some types of economic activity normally are lower in January and February - this winter may have been worse than most.

As Neil Irwin and CEA Chair Jason Furman both note, other indicators - like employment - looked ok during the same period.  Payroll growth averaged 190,000 during the first three months of the year.  That, as Justin Wolfers explains, means a large deviation from the historic relationship between unemployment and output growth known as "Okun's Law".  It also implies a big drop in productivity as we measure it.

Monday, June 16, 2014

Hawks, Doves and (Wesleyan) Cardinals

The Federal Reserve Board welcomed a Wesleyan alum today: Lael Brainard '83 was sworn in (she's second from right, along with Jerome Powell, Janet Yellen and Stanley Fisher).
Brainard previously served as Undersecretary of the Treasury for International Affairs; the NY Times' Annie Lowrey wrote a brief profile of Brainard when she stepped down from that post last year.

Thursday, June 12, 2014

Lucas on Keynes

Robert Lucas appears in the history of macroeconomics as the leader of a methodological "revolution" which supplanted the approach, predominant in the postwar era, of aggregate macro models based on Keynes' ideas, with general equilibrium models grounded in the optimizing behavior.  In his keynote address to the 2003 HOPE (History of Political Economy) convention, Lucas reminisced about his training in Keynesian economics as a grad student at Chicago (yes, at Chicago) in the 1960's.  He closes with an appreciative note on what he thinks Keynes was trying to accomplish:
I think that in writing the General Theory, Keynes was viewing himself as a spokesman for a discredited profession. That’s why he doesn’t cite anyone but crazies like Hobson. He knows about Wicksell and all the “classics,” but he is at pains to disassociate his views from theirs, to overemphasize the differences. He’s writing in a situation where people are ready to throw in the towel on capitalism and liberal democracy and go with fascism or corporatism, protectionism, socialist planning. Keynes’s first objective is to say, “Look, there’s got to be a way to respond to depressions that’s consistent with capitalist democracy.” What he hits on is that the government should take some new responsibilities, but the responsibilities are for stabilizing overall spending flows. You don’t have to plan the economy in detail in order to meet this objective. And in that sense, I think for everybody in the postwar period—I’m talking about Keynesians and monetarists both—that’s the agreed-upon view: We should stabilize spending flows, and the question is really one of the details about how best to do it. Friedman’s approach involved slightly less government involvement than a Keynesian approach, but I say slightly.

So I think this was a great political achievement. It gave us a lasting image of what we need economists for. I’ve been talking about the internal mainstream of economics, that’s what we researchers live on, but as a group we have to earn our living by helping people diagnose situations that arise and helping them understand what is going on and what we can do about it. That was Keynes’s whole life. He was a political activist from beginning to end. What he was concerned about when he wrote the General Theory was convincing people that there was a way to deal with the Depression that was forceful and effective but didn’t involve scrapping the capitalist system. Maybe we could have done it without him, but I’m glad we didn’t have to try.
This is consistent with the "Neoclassical Synthesis" view that Keynes himself presaged in chapter 24 of the General Theory, which Brad DeLong discussed on his WCEG blog yesterday and Krugman commented on today (the quote from Lucas makes me wonder if perhaps Lucas and Krugman aren't quite as far apart as they think after all?).

Keynes' Over-worked Grandchildren?

In a New Yorker book review essay, Elizabeth Kolbert revisits one of my favorites, "Economic Possibilities for Our Grandchildren" by John Maynard Keynes:
Keynes delivered an early version of “Economic Possibilities” as a lecture at a boys’ school in Hampshire. He was still at work revising and refining the essay when, in the fall of 1929, the stock market crashed. Some might have taken this as a bad sign; Keynes was undeterred. Though he quickly recognized the gravity of the situation—the crash, he wrote in early 1930, had produced a “slump which will take its place in history amongst the most acute ever experienced”—over the long run this would prove to be just a minor interruption in a much larger, more munificent trend. In the final version of “Economic Possibilities,” published in 1931, Keynes urged readers to look beyond this “temporary phase of maladjustment” and into the rosy beyond.

According to Keynes, the nineteenth century had unleashed such a torrent of technological innovation—“electricity, petrol, steel, rubber, cotton, the chemical industries, automatic machinery and the methods of mass production”—that further growth was inevitable. The size of the global economy, he forecast, would increase sevenfold in the following century, and this, in concert with ever greater “technical improvements,” would usher in the fifteen-hour week.

To Keynes, the coming age of abundance, while welcome, would pose a new and in some ways even bigger challenge. With so little need for labor, people would have to figure out what to do with themselves: “For the first time since his creation man will be faced with his real, his permanent problem—how to use his freedom from pressing economic cares, how to occupy the leisure, which science and compound interest will have won.”
As Kolbert notes, Keynes' predictions about growth were pretty well on-target. He wrote: "I would predict that the standard of life in progressive countries one hundred years hence will be between four and eight times as high as it is to-day."  That implies an annual growth rate between 1.39% and 2.08%.  According to Maddison project data, UK real GDP per capita rose 4.37 fold between 1930 (when Keynes wrote) and 2010, which gives an annual growth rate of 1.84%.

While Keynes was correct about growth, his prediction about leisure has not come true.  At least not fully - hours worked have fallen, though much more in Europe than in the US -
but even Western Europe is far short of "three hour shifts or a fifteen-hour week." 

That we're still working so much calls into question how we think about work, leisure and preferences.

Among the explanations are:"conspicuous busyness" - i.e., that appearing overworked is a signal; Paul Krugman discussed this on his blog a while back:
First of all, [James Surowiecki is] right that for what he calls knowledge workers — I’d just say elite workers in general — the whole time ethos has changed. When I was growing up on Long Island, there was a clear class hierarchy on commute times. Early trains were filled with menial workers; the later the train the more and fancier suits, with executives starting their day at 9:30 or 10. These days it is if anything reversed: lots of hard-driving suits on the early trains, much more mixed later on.
So what is this about? Surowiecki emphasizes the incentives of employers, and their difficulty in taking the negative effects on productivity into account. My sense, however, is that the most important factor — which he alludes to but doesn’t put at the center — is signaling. Working insane hours is a sign of commitment, of willingness to sacrifice for the job; the personal destructiveness of the practice isn’t a bug, it’s a feature.
This may be true in parenting, as well - as Kolbert writes (referring to "Overwhelmed" by Brigid Schulte): 
One theory she entertains early on is that busyness has acquired social status. The busier you are the more important you seem; thus, people compete to be—or, at least, to appear to be—harried. A researcher she consults at the University of North Dakota, Ann Burnett, has collected five decades’ worth of holiday letters and found that they’ve come to dwell less and less on the blessings of the season and more and more on how jam-packed the previous year has been. Based on this archive, Burnett has concluded that keeping up with the Joneses now means trying to outschedule them. (In one recent letter, a mother boasts of schlepping her kids to so many activities that she drives “a hundred miles a day.”) “There’s a real ‘busier than thou’ attitude,” Burnett says. 
Another hypothesis is that people derive satisfaction and a sense of identity from work.  Kolbert quotes from "Revisiting Keynes" - 
A third group of economists challenges the Keynesian presumption that leisure is preferable to labor. Work may not set us free, but it lends meaning to our days, and without it we’d be lost. In the view of Edward Phelps, of Columbia University, a career provides “most, if not all, of the attainable self-realization in modern societies.” Richard Freeman, of Harvard, is, if possible, more emphatic. “Hard work is the only way forward,” he writes. “There is so much to learn and produce and improve that we should not spend more than a dribble of time living as if we were in Eden. Grandchildren, keep trucking.”  
Phelps and Freeman are correct that our standard treatment of work (bad) versus leisure (good) often misses something important.  This was present in the early "romantic" Marx, who said, "man is a tool-using animal".  The relevance varies a great deal, I suspect - some of us have the good fortune not to feel "alienated" from our labor, though, for many, work is the drudgery that standard economic theory assumes it to be. 

A third explanation relates to the fact that "quality" is a relative concept and the desire for ever-higher quality goods keeps the consumption motive from slackening - this was explained well by Robert Frank in an NYT column.

Friday, May 23, 2014

Accounting and the Liberal Arts

I've had mixed feelings about offering accounting classes in a liberal arts college economics department.  Liberal arts colleges don't typically offer accounting majors or have accounting departments, but an accounting course or two might be on the books in the economics department.

The reason for my reservations about it is that I worry that it reinforces a mis-perception that studying economics is more "vocational" or "practical" than other parts of the liberal arts curriculum - i.e., that an economics major is somehow a proxy for getting a business degree.

However, there is a good case for liberal arts students learning about accounting - financial statements are an important source of information in our society, so being able to interpret them is valuable for anyone who might want to (critically) examine the activities of businesses or the government.

This NY Times opinionator piece by Jacob Soll nicely argues for the value of accounting for an informed citizenry:
The German economic thinker Max Weber believed that for capitalism to work, average people needed to know how to do double-entry bookkeeping. This is not simply because this type of accounting makes it possible to calculate profit and capital by balancing debits and credits in parallel columns; it is also because good books are “balanced” in a moral sense. They are the very source of accountability, a word that in fact derives its origin from the word “accounting.”

A Definition of Business Cycles

Our traditional term for macroeconomic fluctuations - "business cycles" - doesn't really represent well how we think about them now.  Robert Solow provides a good definition:
“the business cycle” has become shorthand for the series of irregular, short-run, aggregative fluctuations of varying duration, magnitude, andprobablycausation that we call prosperity and recession.
That's from Solow's delightful 2007 review of Thomas McCraw's biography of Joseph Schumpeter, which I had the good fortune to stumble upon.

The NBER's somewhat mushy "official" definition is here.