Methodenstreit!

Brad DeLong and Paul Krugman have vigorously criticized some prominent economists - particularly Eugene Fama and John Cochrane - who have offered apparently pre-Keynesian interpretations of the current economic mess. In particular, both seem to suggest that "Say's Law" holds, and therefore, fiscal policy cannot only reallocate - but not increase - output, an argument we thought Keynes had demolished in 1936. Krugman writes:

So how is it possible that distinguished professors believe otherwise?

The answer, I think, is that we’re living in a Dark Age of macroeconomics. Remember, what defined the Dark Ages wasn’t the fact that they were primitive — the Bronze Age was primitive, too. What made the Dark Ages dark was the fact that so much knowledge had been lost, that so much known to the Greeks and Romans had been forgotten by the barbarian kingdoms that followed.

And that’s what seems to have happened to macroeconomics in much of the economics profession. The knowledge that S=I doesn’t imply the Treasury view — the general understanding that macroeconomics is more than supply and demand plus the quantity equation — somehow got lost in much of the profession. I’m tempted to go on and say something about being overrun by barbarians in the grip of an obscurantist faith, but I guess I won’t. Oh wait, I guess I just did.

Or, as he said to Mark Thoma, economists who "have spent their entire careers on equilibrium business cycle theory are now discovering that, in effect, they invested their savings with Bernie Madoff." By "equilibrium business cycle theory," he means the modern incarnation of classical economics, where markets clear and economic fluctuations arise from the behavior of rational, optimizing agents. Greg Mankiw offers a more charitable interpretation:

It is funny. I have a similar pedigree as Paul. Both of us have PhDs from MIT, and we learned a lot of our macro there. Both of us see the world through the lens of the Keynesian framework (by which I mean the IS-LM model, etc.) But we have very different perspectives on the equilibrium business cycle theorists.

The difference may reflect our research paths. Most of Paul's research has been in international economics, and throughout his career, he could easily ignore equilibrium business cycle theory. By contrast, I have done a lot of work on "new Keynesian economics," which tries to fix the flaws in the Keynesian model that the equilibrium business cycle theorists pointed out. Perhaps that work has given me more appreciation for their contribution, as well as for the defects in the Keynesian worldview.

Here is DeLong on Fama, and on Cochrane.

More Stimulus Guesstimates

The stimulus has passed the House and is now cooling in the senatorial saucer. The CBO has estimated its effects:

According to CBO’s estimates, with enactment of H.R. 1, the number of jobs would be between 0.8 million and 2.1 million higher at the end of this year, 1.2 million to 3.6 million higher at the end of next year, and 0.7 million to 2.1 million higher at the end of 2011 than under current law.

As this Times analysis nicely explains, the components vary in their speed and effectiveness - the spending has a higher multiplier than the tax cuts, but some of the spending will take longer to implement. The Tax Policy Center has graded the effectiveness of the tax provisions; they give a B+ to the centerpiece "making work pay" refundable tax credit of $500 for individuals and $1000 for couples, while the corporate tax breaks mostly get lower grades. At Econbrowser, Menzie Chinn plots the CBO's estimate of spending over time (bear in mind that the CBO's estimates are for the federal government's fiscal years, which begin in October, not January, so we're almost half way through FY 09).

A detailed outline of the bill has been posted by Speaker Pelosi's office.

The Roquefort Files

The Washington Post reports:

In its final days, the Bush administration imposed a 300 percent duty on Roquefort, in effect closing off the U.S. market. Americans, it declared, will no longer get to taste the creamy concoction that, in its authentic, most glorious form, comes with an odor of wet sheep and veins of blue mold that go perfectly with rye bread and coarse red wine.

The measure, announced Jan. 13 by U.S. Trade Representative Susan C. Schwab as she headed out the door, was designed as retaliation for a European Union ban on imports of U.S. beef containing hormones. Tit for tat, and all perfectly legal under World Trade Organization rules, U.S. officials explained.

Is it just me, or does this smell like a parting shot at cheese-eating surrender monkeys?

Update (2/1): The Economist's Free Exchange says: "Yes, while Europeans will be relishing delicious bleu cheese, Americans can eat hormone-injected beef with a side of stale freedom fries."

Old School

From Davos, of all places, the Times reports:Don't forget to include their running-dog lackeys.

Keynes and FDR

From an interesting Times article on the lessons of the depression:

In 1934, the British economist John Maynard Keynes visited Roosevelt in the White House to make his case for more deficit spending. But Roosevelt, it seems, was either unimpressed or uncomprehending. “He left a whole rigmarole of figures,” Roosevelt complained to his labor secretary, Frances Perkins, according to her memoir. “He must be a mathematician rather than a political economist.”

Keynes left equally disenchanted, telling Ms. Perkins that he had “supposed the president was more literate, economically speaking.”

A Crisis of Animal Spirits

In the WSJ, Yale's Robert Shiller argues for the relevance of the Keynes beyond the "textbook" Keynesian model:

The term "animal spirits," popularized by John Maynard Keynes in his 1936 book "The General Theory of Employment, Interest and Money," is related to consumer or business confidence, but it means more than that. It refers also to the sense of trust we have in each other, our sense of fairness in economic dealings, and our sense of the extent of corruption and bad faith. When animal spirits are on ebb, consumers do not want to spend and businesses do not want to make capital expenditures or hire people...

But lost in the economics textbooks, and all but lost in the thousands of pages of the technical economics literature, is this other message of Keynes regarding why the economy fluctuates as much as it does. Animal spirits offer an explanation for why we get into recessions in the first place -- for why the economy fluctuates as it does. It also gives some hints regarding what we need to do now to get out of the current crisis...

The famous phrase comes from this passage in chapter 12 of the General Theory:

Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits - of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities. Enterprise only pretends to itself to be mainly actuated by the statements in its own prospectus, however candid and sincere. Only a little more than an expedition to the South Pole, is it based on an exact calculation of benefits to come. Thus if the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die; - though fears of loss may have a basis no more reasonable than hopes of profit had before.

Krugman Debunks Stimulus Skeptics

In his Times column, Paul Krugman provides a useful rebuttal of some of the arguments being made against the stimulus proposal, including:

First, there’s the bogus talking point that the Obama plan will cost $275,000 per job created. Why is it bogus? Because it involves taking the cost of a plan that will extend over several years, creating millions of jobs each year, and dividing it by the jobs created in just one of those years.

It’s as if an opponent of the school lunch program were to take an estimate of the cost of that program over the next five years, then divide it by the number of lunches provided in just one of those years, and assert that the program was hugely wasteful, because it cost $13 per lunch. (The actual cost of a free school lunch, by the way, is $2.57.)

The true cost per job of the Obama plan will probably be closer to $100,000 than $275,000 — and the net cost will be as little as $60,000 once you take into account the fact that a stronger economy means higher tax receipts.

Emerging Markets, Foiled Again

Whatever happens in the world economy, developing countries always seem to get the worst of it. After the financial crises of the late 1990's, many "emerging market" countries sought to reduce their dependence on fickle financial inflows by building up reserves. This entailed running trade surpluses - selling goods in exchange for financial assets - with the perverse implication that low-income countries were net lenders to the US and other high-income "surplus" countries.

Initially, there was great hope that their fortunes had "decoupled" from the US, but, alas, they may be even in worse shape. Brad Setser puts it well:

Emerging economies who thought that they had protected themselves from sudden swings in capital flows by maintaining large reserves and running large external surpluses are discovering that their efforts to reduce their exposure to volatile global capital flows added to their exposure to a global slump in trade.

Gov. Strickland, Hold that Axe!

And you, too, President Hodge. The Center on Budget and Policy Priorities has provided a useful state-by-state breakdown of some of the elements in the stimulus package proposed by the House Democrats designed to help states, education and low-income households. Here is what they estimate Ohio would get from certain provisions, over two years, with the national total in parenthesis:

• Temporary increase in Federal share of Medicaid: $2.8bn ($82.5bn)
• State education block grants: $1.4bn ($38.8bn)
• Block grants for other state services: $0.9bn ($24.8bn, [+$15bn unallocated])
• Other education spending: $1.7bn ($41bn)
• Training and employment services: $0.2bn ($2.7bn, [+$1.3bn unallocated], over 1yr)

Those pieces alone add up to about $7bn for Ohio, and that is not including some of the other major elements, such as infrastructure spending and tax cuts. So it looks like the help from Washington could go a long way towards closing the state budget gap, which is projected to be $7.3bn for the 2010-11 fiscal year.

Do We Need An Insurer of Last Resort?

At Vox, MIT's Ricardo Caballero offers an interesting take on the financial crisis. He sees it as following from an increased global demand for safe (i.e., AAA-rated) assets:

For quite some time, but in particular since the late 1990s, the world has experienced a chronic shortage of financial assets to store value. The reasons behind this shortage are varied. They include the rise in savings needs by aging populations in Japan and Europe, the fast growth and global integration of high saving economies, the precautionary response of emerging markets to earlier financial crises, and the intertemporal smoothing of commodity producing economies.

The immediate consequence of the high demand for store-of-value instruments was a sustained decline in real interest rates. Conventional wisdom blames these low rates on loose monetary policy, but this position is difficult to reconcile with facts from the period of the so-called “Greenspan conundrum’’ – when tightening monetary policy had virtually no impact on long rates. In my view, the solution to the apparent conundrum is that low long rates were driven by the large demand for store-of-value instruments, not short-term monetary policy considerations.

That is, Bernanke's famous "savings glut," with an added tilt towards risk aversion. The "subprime" mess is a result of the attempts of the financial sector to manufacture assets to meet this demand:

Under this perspective, there is a more subtle angle on subprime mortgages than simply being the result of unscrupulous lenders. The world needed more assets and the subprime mortgages were helping to bridge the gap. So far so good.

However, there was one important caveat that would prove crucial later on. The global demand for assets was particularly for very safe assets – assets with AAA credit ratings. This is not surprising in light of the importance of central banks and sovereign wealth funds in creating this high demand for assets. Moreover, this trend toward safety became even more pronounced after the NASDAQ crash.

Soon enough, US banks found a “solution” to this mismatch between the demand for safe assets and the expansion of supply through the creation of risky subprime assets; the market moved to create synthetic AAA instruments. This consisted of pooling subprime mortgages on the asset side of a Structured Investment Vehicle (SIV), and to tranch (slice) the liability side to generate a AAA component buffered by the now ultra volatile “toxic” residual. The latter was then pooled again into Collateralized Debt Obligations (CDOs), tranched again, and then into CDO-squared, and so on. At the end of this iterative process, many new AAA assets were produced out of some very risky subprime mortgages.

In a second column, he argues the financial system is afflicted with "Knightian uncertainty" - the possibility of truly unknowable outcomes, as opposed to standard "risk" where economists and financiers can attach a probability distribution to a set of known outcomes. The appropriate policy solution, therefore, is for the government to step in and take an increased role as an insurer (like it did for Citi):

Essentially, the US (and other) financial markets are experiencing the modern version of a systemic run as we had not seen since the Great Depression. It used to be that depositors ran from banks. Some of this still happens, but runs in modern financial markets, to be systemic, have to involve a larger class of assets. A run against explicit and implicit financial insurance is essentially a run against virtually all private sector financial transactions but for those with the shortest maturities. Thus, the modern lender-of-last resort facility has to be a provider of broad insurance, not just deposit insurance. This is what it will take to get us back into a reasonable equilibrium where we can initiate a recovery from a (more) “normal” recession.

We will see if the second round of the TARP and future Fed improvisations incorporate more of an insurance component, which would involve the government taking on more contingent liabilities, rather than spending directly (which might be a way of getting around budget limits imposed by Congress, for better or worse). One thing we can be sure of is that the ballooning deficit means that the federal government will be making plenty of safe assets (Treasury bonds) available.