Pigou!

In the Journal, John Cassidy profiles A.C. Pigou, the Cambridge (UK) economist who pioneered the concept of externalities.

Keynes' Bad Grandchildren

At project syndicate, Keynes' biographer Robert Skidelsky revisits "Economic Possibilities for Our Grandchildren." While we have achieved economic growth even slightly better what Keynes hoped for, our attitudes towards work and wealth have not changed in the ways he predicted. In particular, the fact that we can now afford what would be a very high material standard of living in Keynes' day with much less work should have freed us to "live wisely, agreeably and well."

Skidelsky offers a very gloomy interpretation:

Moreover, Keynes did not really confront the problem of what most people would do when they no longer needed to work. He writes: “It is a fearful problem for the ordinary person, with no special talents, to occupy himself, especially if he no longer has roots in the soil or in custom or in the beloved conventions of a traditional economy.” But, since most of the rich – “those who have an independent income but no associations or duties or ties” have “failed disastrously” to live the “good life,” why should those who are currently poor do any better?

Here I think Keynes comes closest to answering the question of why his “enough” will not, in fact, be enough. The accumulation of wealth, which should be a means to the “good life,” becomes an end in itself because it destroys many of the things that make life worth living. Beyond a certain point – which most of the world is still far from having reached – the accumulation of wealth offers only substitute pleasures for the real losses to human relations that it exacts.

Hmmm... My favorite hypothesis on this remains Robert Frank's.

Don't Like International Capital Mobility?

Blame French socialists, says Dani Rodrik (in the context of a Project Syndicate column in favor of Brazil's tax on short term capital flows):

It may seem curious that [IMF Managing Director] Strauss-Kahn’s instincts are so off the mark on the matter of capital controls. One might have thought that a socialist, and a French Socialist at that, would be more inclined toward finance skepticism.

But the paradox is more apparent than real. Financial markets in fact owe French Socialists a great debt. Received wisdom holds the United States Treasury and Wall Street responsible for the push to free up global finance. But far more influential may have been the change of heart that took place among French Socialists following the collapse of their experiment in Keynesian reflation in the early 1980’s. When capital flight forced François Mitterrand to abort his program in 1983, France’s Socialists performed an abrupt volte-face and embraced financial liberalization on a global scale.

According to Harvard Business School’s Rawi Abdelal, this was the key event that set in motion the developments that would ultimately enshrine freedom of capital movement as a global norm. The first stop was the European Union in the late 1980’s, where two French Socialists – Jacques Delors and Pascal Lamy (the president of the European Commission and his assistant, respectively) – led the way. Then it was the turn of the Organization of Economic Cooperation and Development (OECD). Eventually, the IMF joined the bandwagon under Michel Camdessus, another Frenchmen who had served as Governor of the Bank of France under Mitterrand.

Unrealism is Not the Problem

At Vox, Paul DeGrawe describes contemporary macro models as "top down" because agents are assumed to know the structure of the world they live in. He writes:

There is a general perception today that the financial crisis came about as a result of inefficiencies in the financial markets and economic actors’ poor understanding of the nature of risks. Yet mainstream macroeconomic models, as exemplified by the dynamic stochastic general equilibrium (DSGE) models, are populated by agents who are maximising their utilities in an intertemporal framework using all available information including the structure of the model – see Smets and Wouters (2003), Woodford (2003), Christiano et al. (2005), and Adjemian, et al. (2007), for example. In other words, agents in these models have incredible cognitive abilities. They are able to understand the complexities of the world, and they can figure out the probability distributions of all the shocks that can hit the economy. These are extraordinary assumptions that leave the outside world perplexed about what macroeconomists have been doing during the last decades.

In its place, he advocates the modeling the economy as a "bottom up" system:

Bottom-up systems are very different in nature. These are systems in which no individual understands the whole picture. Each individual understands only a very small part of the whole. These systems function as a result of the application of simple rules by the individuals populating the system.

While I do think this is worth exploring (his paper will be on my holiday break reading list), his description of contemporary macroeconomics is not quite fair. The models do not imply that macroeconomists believe people really have all this knowledge (we most of us know better than that). Rather, we believe it makes sense to model them as if they do. Milton Friedman famously made this point by noting that it makes sense to model the shots of a champion billiard player as if he has a sophisticated understanding of physics.

It is worth recalling that macroeconomics adopted the paradigm of rational expectations and dynamic optimization because simple and apparently realistic assumptions like adaptive expectations led to situations where people could systematically and repeatedly be fooled, and this tendency could be exploited by policymakers. While rational expectations may be unrealistic, in a world where people are learning and updating their beliefs, one would expect tendencies that lead to significantly suboptimal outcomes to be driven out (and in the context of markets, with the help of competition). So, while real people are groping around in the fog trying to figure out a rough idea of how the world works, we would expect them to arrive at behaviors consistent with those of rational forward looking agents just as a billiard player, by trial-and-error, learns to make shots consistent with the laws of physics.

So the "unrealism" of the assumptions is not, by itself, a problem. The trouble arises if that unrealism leads us to incorrect predictions. Macroeconomics may indeed have gone astray in some ways, and the lack of realism in models may indeed vex non-economists, but the assumption of "incredible cognitive abilities" is not inherently a problem.

Update (11/22): I had a chance to a look at DeGrawe's paper (pdf). Although I disagree with his characterization of modern macroeconomics, I do think his paper is interesting, though I suspect it may be vulnerable to some of the same criticisms as adaptive expectations models. (via Mark Thoma's link to the "Whats Wrong with Modern Macroeconomics" conference papers).

Bart and Marge on Grad School

A grad school friend calls this to my attention:

One part of the transition from being a grad student to a professor that I found somewhat disorienting was the change from being treated with such disrespect - though our undergrad students were too polite to make comments like Bart's and Marge's, we knew what they were thinking - to receiving such deferential treatment as a professor. This big change in status felt particularly strange because it came in spite of the fact that there was little change in what I actually did every day - teaching and research - when I went from grad student to professor.

Double-Digits, Yikes!

I had hoped we wouldn't get here...

Not a nice headline number from the BLS today - the unemployment rate hit 10.2% in October. Payroll employment also fell by 190,000. The apparent discrepancy between the relatively modest decline in payrolls and the big jump in the unemployment rate is explained by the fact that the numbers come from two different sources. The unemployment rate is measured using a survey of households, while the payroll figure comes from a survey of firms. In this case, the divergence between the two was wide - according to the household survey, 589,000 jobs were lost. And there is no consolation from labor force participation, which ticked downward slightly.

Nonetheless, I see the folks at FRED have moved us out of the shaded area... presumably on the strength of the recent preliminary estimate of 3.5% GDP growth in the third quarter. Of course if output is growing, and employment is falling, productivity is rising. The BLS indeed reported a stunning 9.5% rate of increase in labor productivity for the third quarter. The accompanying decline in labor costs ought to be a pretty big inducement to hire more workers, but it is not clear that firms are confident that the demand will be there if they increase output.

Meanwhile, Paul Krugman reports the President is pinned down on the beachhead...

Update (11/9): Floyd Norris points out that the non-seasonally adjusted unemployment rate is 9.5%, unchanged from last month (and down from a peak of 9.7% in June-July).

Unemployment Rate, Not Seasonally Adjusted

Now that looks better! Hmm...

A New Cop on the Imbalances Beat?

The President's trip to China next week induces a bit of nostalgia for those famous "summit" meetings of the Cold War, when the "leader of the free world" would go "toe-to-toe with the Russkies."

Of course its far better, though perhaps less dramatic, that the meetings will deal with the "balance of financial terror" instead of nuclear terror. One element of reducing that terror will be convincing China to relax its de facto Dollar peg (but not too abruptly, please). Simon Johnson suggests an approach to deal with this issue:

Talking in public about big sticks never goes down well in Asia, and the administration should deny any inclination in this direction. But the mainstream consensus is starting to shift toward the idea that the World Trade Organization (W.T.O.), not the I.M.F., should have jurisdiction over exchange rates. The W.T.O. has much more legitimacy, primarily because smaller and poorer countries can bring and win cases against the United States and Western Europe in that forum. It also has agreed upon and proven tools for dealing with violations of acceptable trade practices; tailored trade sanctions are permitted.

No one wants to take precipitate action in this direction, but extending the W.T.O.’s mandate in the direction of exchange rates would take time — and presumably warrant discussion at the G-20 level. The United States has great influence over the G-20 agenda, and Mr. Obama’s staff members should hint, ever so gently, that this is where they see the process going.

Hmmm... living in Middletown Connecticut and Oxford Ohio, I'd missed the shift in the "mainstream consensus." Very interesting...

The Darkest Hour

is just before the dawn?

Perhaps, says David Leonhardt, who looks back at at the pessimism that prevailed in 1982:

In the fall of 1982, with a long recession ending but the unemployment rate heading toward 10 percent, The New York Times ran an article titled “The Recovery That Won’t Start.”

It quoted prominent economists who worried that “the recovery may amount to nothing more than a few quarters of paltry growth — and possibly not even that.” The economists, the article noted, had “growing doubts about whether the mechanisms of economic recovery will — or can — operate as they have in other postwar business cycles.”

Or as a classic song of the time put it:

And now you find yourself in '82
The disco hot spots hold no charm for you
You can concern yourself with bigger things
You catch a pearl and ride the dragon's wings

Of course, now we know that what came next were two years of very strong growth and soon it was "Morning in America:"



Perhaps the pessimists were just caught up in the heat of the moment, as Leonhardt suggests:

People tend to become overly pessimistic at the end of a recession, partly because they can see that the forces behind the last boom — housing and mortgage lending, in this case — won’t be around for the next one. If anything, the excesses from the last boom seem likely to hold back the economy for years to come. People are left to wonder where future growth will come from.

He has hope that we may indeed ride the dragon's wings to recovery:

For years, economists have been saying that China needs to consume more and the United States needs to consume less. Now it’s starting to happen.

The Chinese government has increased spending in the country’s impoverished countryside and made it easier for households to borrow money. Meanwhile, the global recession has caused China’s export sector to shrink.

However, Calculated Risk argues (seconded by Krugman) that today's situation compares unfavorably to that of 1982 because financial-crisis recessions generally tend to be longer, and because the Fed is out of room to lower interest rates.

Hmmm... only time will tell.