DeLong Answers Kocherlakota

Brad DeLong responds to the claim made in Minneapolis Fed President Narayana Kocherlakota's essay on the state of macro (see earlier post) that:

I believe that during the last financial crisis, macroeconomists (and I include myself among them) failed the country, and indeed the world. In September 2008, central bankers were in desperate need of a playbook that offered a systematic plan of attack to deal with fast-evolving circumstances. Macroeconomics should have been able to provide that playbook. It could not.

DeLong argues that a better understanding of how to respond to economic crises exists, even if it is outside of Kocherlakota's realm of "modern macroeconomics." He goes back to John Stuart Mill:

Let me briefly set out what the macro playbook is, and how it has been developed by economists and policymakers over the past 185 years. Start with Say's or Walras's Law: the circular flow principle that everybody's expenditure is someone else's income--ands everyone's income is somebody else's expenditure. It has to be that way: for every buyer there is a seller: and for every seller who is disappointed because they sell for less than their cost plus normal profit because of excess supply there must be another who is exuberant from selling at more than cost plus normal profit.

How, then, can you have a depression--a "general glut," a situation in which there is excess supply of not one or a few but all commodity goods and services? How can you have a situation in which workers laid off from shrinking industries where demand is less than was expected and thus less than supply are not rapidly hired into industries where demand is more than was expected and hence more than supply?

Moral philosopher, libertarian, colonial bureaucrat, feminist, public intellectual, and economist John Stuart Mill put his finger on the answer in a piece he published in 1844:

[T]hose who have... affirmed that there was an excess of all commodities, never pretended that money was one of these commodities.... [P]ersons in general, at that particular time, from a general expectation of being called upon to meet sudden demands, liked better to possess money than any other commodity. Money, consequently, was in request, and all other commodities were in comparative disrepute. In extreme cases, money is collected in masses, and hoarded; in the milder cases, people merely defer parting with their money, or coming under any new engagements to part with it. But the result is, that all commodities fall in price, or become unsaleable...

DeLong puts the problem in terms of a shortage of "safe" assets. The policy response of creating more of them - issuing more government bonds - is the flip side of the traditional Keynesian remedy of deficit spending (or deficit financed tax cuts), as well as of an aggressive "lender of last resort" central bank policy. See also DeLong's related project syndicate column, and this Vox piece by Ricardo Caballero.

So, is this further evidence that we are living in what Krugman called the "dark age of macroeconomics"? Yes and no. As DeLong notes, policymakers have largely been following his playbook (though there are ominous signs they are pulling back too soon). However, academic models employing the reigning methodology of "dynamic stochastic general equilibrium" (DSGE) have generally not been very helpful. That paradigm is still relatively young - it remains to be seen if it will develop in a direction that makes it more useful for policy, or whether it will be supplanted in a more fundamental shift.

Feldstein on the Euro

At Project Syndicate, Martin Feldstein says the Euro was doomed from the start:

The attempt to establish a single currency for 16 separate and quite different countries was bound to fail. The shift to a single currency meant that the individual member countries lost the ability to control monetary policy and interest rates in order to respond to national economic conditions. It also meant that each country’s exchange rate could no longer respond to the cumulative effects of differences in productivity and global demand trends.

In addition, the single currency weakens the market signals that would otherwise warn a country that its fiscal deficits were becoming excessive. And when a country with excessive fiscal deficits needs to raise taxes and cut government spending, as Greece clearly does now, the resulting contraction of GDP and employment cannot be reduced by a devaluation that increases exports and reduces imports.

So Its Not Too Late

to change my major, after all...

according the e-mail newsletter of the Western Economic Association:link here.

Rodrik on Greece

At Project Syndicate, Dani Rodrik writes:

Deep down, the crisis is yet another manifestation of what I call “the political trilemma of the world economy”: economic globalization, political democracy, and the nation-state are mutually irreconcilable. We can have at most two at one time. Democracy is compatible with national sovereignty only if we restrict globalization. If we push for globalization while retaining the nation-state, we must jettison democracy. And if we want democracy along with globalization, we must shove the nation-state aside and strive for greater international governance.

So we must learn to accept that, in the immortal words of Meat Loaf, "two out of three ain't bad."

The State of Macro

Greg Mankiw points out a nice essay on modern macro by Minneapolis Fed President Narayana Kocherlakota. A week too late for this semester, but definitely on the reading list for the next equilibrium macroeconomics course.

Kocherlakota argues that macro has largely gotten beyond the "saltwater" - "freshwater" schism that has, I think, been overplayed in much of the conversation about macroeconomics and the recession (including Krugman's widely noted NYT magazine article, that I responded to in this post). His picture is of a field that is more pragmatic than ideological. For example, he suggests the use of "social planner" solutions in dynamic stochastic general equilibrium models has been more a matter of convenience than of a rigid belief that perfectly competitive market conditions hold at all times. He writes:

My own idiosyncratic view is that the division was a consequence of the limited computing technologies and techniques that were available in the 1980s. To solve a generic macro model, a vast array of time- and state-dependent quantities and prices must be computed. These quantities and prices interact in potentially complex ways, and so the problem can be quite daunting.

However, this complicated interaction simplifies greatly if the model is such that its implied quantities maximize a measure of social welfare. Given the primitive state of computational tools, most researchers could only solve models of this kind. But—almost coincidentally—in these models, all government interventions (including all forms of stabilization policy) are undesirable.

With the advent of better computers, better theory, and better programming, it is possible to solve a much wider class of modern macro models. As a result, the freshwater-saltwater divide has disappeared. Both camps have won (and I guess lost). On the one hand, the freshwater camp won in terms of its modeling methodology. Substantively, too, there is a general recognition that some nontrivial fraction of aggregate fluctuations is actually efficient in nature.

On the other hand, the saltwater camp has also won, because it is generally agreed that some forms of stabilization policy are useful. As I will show, though, these stabilization policies take a different form from that implied by the older models (from the 1960s and 1970s).

PHD PTSD

I made the mistake of taking a glance at the web page of my graduate alma mater:
In sympathy, I'll hide under the covers.

About That Mediterranean Work Ethic

According to many accounts of the financial crisis in Europe, one reason intervention has been slow is that it is hard to convince Germans, widely seen by themselves and others as hard-working, thrifty and virtuous, to "bail out" those lazy, spendthrift Greeks.

This bit of OECD data on hours worked per worker (via Economix) runs contrary to the stereotypes:
That is, according to the OECD, the average Greek worker logs 2120 hours per year - 690 more than a German worker.

Holding Out for a Euro

In Friday's Paul Krugman column, gloom about Greece:

Greece’s problems are deeper than Europe’s leaders are willing to acknowledge, even now — and they’re shared, to a lesser degree, by other European countries. Many observers now expect the Greek tragedy to end in default; I’m increasingly convinced that they’re too optimistic, that default will be accompanied or followed by departure from the euro.

Barry Eichengreen is a relative optimist, but even his roadmap out of the crisis begins with a debt restructuring:

European leaders and the IMF have badly bungled their efforts to stabilise Europe’s financial markets. They have one last chance, but success will require a radical change in mindset.

First the easy part: Greece will restructure its debt. This point is no longer controversial; the only controversy is why a restructuring was not part of the initial IMF-EU rescue package.

Only the delusional can believe that, when everyone else is taking swingeing cuts, Greece's creditors can continue receiving 100 cents on the euro. It beggars belief that Greek government debt can top out at 150% of GDP, as the IMF envisages. At this point the government will be transferring well more than 10% of national income to the creditors. In a time of severe austerity, this outcome is unsustainable both economically and politically.

The lack of a restructuring seems the most obvious weakness of the current rescue plan; on this The Economist makes an astute point:

EU governments and the IMF refuse to discuss the possibility of an eventual rescheduling of Greek debt for fear that it would spark uncontrolled contagion. In fact, the logic may increasingly be the opposite. By refusing to admit that Greece faces an obvious solvency problem, whereas Spain, Portugal and Ireland do not, Europe’s policymakers have made it harder to draw a clear distinction between Greece and the rest. As a result contagion has intensified.

Why is the Greek government so hesitant to make a move that seems so obviously necessary? In a Vox column, Edwardo Borzenstein and Ugo Panizza offer a political economy insight from their research:

[D]efault episodes seem to have high political costs. We find that, on average, ruling governments in countries that defaulted observed a 16 percentage point decrease in electoral support. We also look at changes in top economic officials and show that in any given tranquil year there is a 19% probability of observing a change in the finance minister, but after a default episode the probability jumps to 26%. The presence of such political costs has two implications. On the positive side, a high political cost would increase the country’s willingness to pay and hence its level of sustainable debt. On the negative side, politically costly defaults might lead to ‘‘gambles for redemption’’ and possibly amplify the eventual economic costs of default if the gamble does not pay off and results in larger economic costs.

Krugman's column also prompted an interesting exchange on optimum currency areas - the crisis shows that Europe isn't one, but how sure are we that the US is? - among Greg Mankiw, David Beckworth, and Krugman.

On Greece, see also Ezra Klein's conversation with Desmond Lachman and this Vox column with advice from Domingo Cavallo (!!*), which includes an interesting idea about how Greece (and Portugal and Spain) could improve competitiveness without devaluation by shifting taxes from labor to consumption.

*Argentina's Finance Minister during its 2001 crisis.

Bad Headline, Better News

It was not pleasant to wake up to the news that the unemployment rate rose to 9.9% in April (from 9.7% in March), but, behind that discouraging headline number, the other figures in the BLS employment situation report are more positive.

The key thing to remember unemployment rate is calculated as the number of people unemployed as a fraction of the labor force, which includes both employed people and those who are looking for work. In April, the labor force surged by 805,000 which suggests that some people who had given up on looking for work were drawn back into the labor market. This is reflected in an increase in the labor force participation rate, to 65.2%.

Labor Force Participation Rate

According to the household survey (from which the unemployment and labor force participation rates are calculated), the number of people employed rose by 550,000, and the employment-population ratio increased to 58.8%.

Employment-Population Ratio

The establishment survey yielded an increase in employment of 290,000. Some of that is government hiring for the census, but private payrolls were up 231,000.

Overall, the April numbers suggest things are moving in the right direction. Because so many people had left the labor force during the downturn, the unemployment rate has been understating how bad things are. The increase serves to remind us - and our policymakers - how deep the hole is.

Also, it may be worth noting seasonal adjustment contributed to the change - the unadjusted unemployment rate was 10.2% in March and 9.5% in April (that is, the BLS tries to remove the 'normal' month-to-month changes that occur within every year, including a significant improvement that occurs every April).

This Recession is Un-'Real'

One way in which the recent recession - particularly the later part of it - has been unusual is that productivity growth has been very strong, as can be seen in the BLS index of output per hour worked:That is in contrast to the usual pro-cyclical pattern, where productivity suffers during recessions: The historical association between productivity and employment declines lends at least superficial plausibility to the "real business cycle" (RBC) story wherein fluctuations result from optimizing agents choosing to work less (and enjoy more leisure) during periods where their marginal products are relatively low. While many find the RBC story dubious for other reasons (see, e.g., Larry Summers), the behavior of labor and productivity over last couple of years would appear to directly contradict it.

The rapid productivity growth has also caused a violation of the "Okun's Law" rule of thumb relating output growth to unemployment, as we have had an even larger increase in unemployment than the path of output would normally imply. This was examined in a recent San Francisco Fed Letter by Mary Daly and Bart Hobijn, which included this figure: Today's BLS numbers suggest the productivity boomlet is tapering off. The AP's Martin Crutsinger writes:

U.S. companies are running out of ways to increase productivity from leaner workforces, a sign that they may need to step up hiring in the months ahead.

That was the takeaway from reports released Thursday by the Labor Department.

Productivity grew at an annual rate of 3.6 percent in the first quarter, better than economists had expected. But it still declined sharply from growth that exceeded 6 percent for each of the previous three quarters....

Now, economists think companies are nearing the limits of how much they can expand output without hiring more workers.

"Companies addressed the post-Lehman collapse in the economy with a massive wave of layoffs. With demand now picking up ... they need to hire again," said Ian Shepherdson, chief U.S. economist at High Frequency Economics.

Normally, I wouldn't be rooting against productivity growth since it is, after all, why the US and much of the world has become rich, but, under the circumstances, I hope he's right.

One Instrument, How Many Objectives?

Some have blamed the Fed's low interest rates for the housing bubble. For example, in a Washington Post op-ed, Roger Lowenstein writes:

Critics of the Fed have long urged it to intervene in bubbles -- an argument that seems even stronger now. Had the Fed raised interest rates more aggressively in the early part of the decade, it is possible that banks would not have made so many questionable loans. We can't know for sure, of course. But we do know what did happen: From 2001 to 2003, the Fed lowered short-term interest rates 13 times, reaching a rock-bottom level of 1 percent. They stayed there another year, and thereafter rose at a painstaking pace. With credit so cheap, people and institutions borrowed as if there were no tomorrow. And when the bust came, it spawned the worst recession in 75 years.

What could the Fed have done about it? By law, the central bank is responsible for promoting maximum economic growth while maintaining stable prices. When bubbles burst, they wreak havoc on the economy, so reining them in should be considered part and parcel of keeping the economy growing.

This line of argument implies that the fed funds rate should have been higher in 2001-03. When one looks at the unemployment rate (red line), which was high, and inflation (blue line), which was low, the Fed's policy (green line) at the time seems pretty understandable.Recent experience provides good reason for reconsidering whether the Fed should pay more attention to possible asset price and credit bubbles. Using the traditional tool of adjusting the federal funds rate target to "pop" bubbles, however, burdens that single policy instrument with a third objective. Simultaneously keeping inflation and unemployment low has proven tricky enough. A more promising direction, I think, would be to consider whether regulatory tools, like bank leverage requirements, could be applied in a countercyclical fashion.