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March 11, 2009

Economist's View - 5 new articles

You Make the Call

The voting is pretty one-sided so far:

Are we all Keynesians now?

Tax Cuts and Work Effort across Income Levels

A revenue neutral change that makes taxes more progressive increases work effort. That is, when taxes on the middle class go down by a dollar and taxes on the wealthy go up by a dollar, the increase in work effort by middle class workers more than offsets and fall in work effort by the wealthy:

So, based on my research, if a need to raise some revenue means tax rates have to be increased for someone, raising them on the wealthiest will result in a smaller reduction in work effort than raising tax rates on the middle class.

That's Julie Hotchkiss reporting on her research in macroblog. There is a catch:

An additional relevant question remains: What is the implication of changing work effort for GDP growth? The relationship between work effort and value of output is not necessarily the same across income levels. In other words, one hour of high-income (higher education) labor is expected to yield a higher value of output in the economy than one hour of labor from a middle-income (lower education) worker. A complete analysis of the aggregate impact of the administration's tax plan would have to also take this into account.

However, the effect on growth is only one metric by which to judge this policy, e.g. the benefits to the household that come from one more hour of work may also differ across income levels, particularly if the additional money is used to buy necessities in one case, and luxuries in the other.

Greenspan: The Fed Didn't Do It

Alan Greenspan takes on John Taylor's claim that the Fed caused the housing bubble, and he warns against "micromanagement by government" regulators. Greenspan says the Fed couldn't have caused the housing bubble because it lost control over long-term interest rates once financial markets became globalized, and those were the rates that caused the problem:

The Fed Didn't Cause the Housing Bubble, by Alan Greenspan, Commentary, WSJ: ...The Federal Reserve became acutely aware of the disconnect between monetary policy and mortgage rates when the latter failed to respond as expected to the Fed tightening in mid-2004. Moreover, the data show that home mortgage rates had become gradually decoupled from monetary policy even earlier...

[T]he presumptive cause of the world-wide decline in long-term rates was the ... surge in growth in China and a large number of other emerging market economies that led to an excess of global ... savings... That ... propelled global long-term interest rates progressively lower between early 2000 and 2005.

That decline in long-term interest rates across a wide spectrum of countries statistically explains, and is the most likely major cause of ... the global housing price bubble. ... I would have thought that ... such evidence would lead to wide support for ... a global explanation of the current crisis.

However, starting in mid-2007, history began to be rewritten, in large part by ... John Taylor... Mr. Taylor unequivocally claimed that had the Federal Reserve from 2003-2005 kept short-term interest rates at the levels implied by his "Taylor Rule," "it would have prevented this housing boom and bust." This notion has ... taken on the aura of conventional wisdom.

Aside from the inappropriate use of short-term rates to explain the value of long-term assets, his statistical ... analysis carries empirical relationships of earlier decades into the most recent period where they no longer apply.

Moreover,... the "Taylor Rule" ... parameters and predictions derive from model structures that have been consistently unable to anticipate the onset of recessions or financial crises. Counterfactuals from such flawed structures cannot form the sole basis for successful policy analysis or advice, with or without the benefit of hindsight. Given the decoupling of monetary policy from long-term mortgage rates,... the Fed ... could not have "prevented" the housing bubble. ...

It is now very clear that the levels of complexity to which market practitioners at the height of their euphoria tried to push risk-management techniques and products were too much for even the most sophisticated market players to handle properly and prudently.

However, the appropriate policy response is not ... heavy regulation. That would stifle important advances in finance that enhance standards of living. ... The solutions for the financial-market failures ... are higher capital requirements and a wider prosecution of fraud -- not increased micromanagement by government entities. ... Adequate capital and collateral requirements ... will not be overly intrusive, and thus will not interfere unduly in private-sector business decisions.

If we are to retain a dynamic world economy capable of producing prosperity and future sustainable growth, we cannot rely on governments to intermediate saving and investment flows. Our challenge in the months ahead will be to install a regulatory regime that will ensure responsible risk management..., while encouraging them to continue taking the risks necessary and inherent in any successful market economy.

We seem to have a disagreement on the scope of regulation. Ben Bernanke:

Bernanke Calls for Broader Regulations, WSJ: Federal Reserve Chairman Ben Bernanke said regulators should be given broad new powers to oversee financial markets... Among his recommendations were tougher capital requirements for big banks, limits on investments by money-market mutual funds, and the introduction of some mechanism that would allow the U.S. to wind down big financial institutions and possibly run them temporarily. ...

The recommendations were largely consistent with measures being pushed by House Financial Services Committee Chairman Barney Frank (D., Mass.), who is expected to be a key architect of the new financial regulation. ...

Mr. Bernanke ... also pushed for much tougher policies over ... big companies. "Any firm whose failure would pose a systemic risk must receive especially close supervisory oversight of its risk-taking, risk management and financial condition, and be held to high capital and liquidity standards," Mr. Bernanke said. ...

I'm in agreement with Greenspan's response to Taylor to the extent that following the Taylor rule wouldn't have stopped the crisis, but I think the low interest rate policy pursued by the Fed is part of the story and served to magnify other factors. As for regulation, relying mainly upon enhanced capital requirements as Greenspan proposes isn't enough, so I'm at least where Bernanke with respect to close supervisory oversight of firms who pose a systemic risk. But I'd go even further and - to the extent possible - break up the firms into smaller entities and sever their interconnections until they no longer posed a threat to begin with. This is harder than it sounds, or so I'm told, but I'd still pursue the option.

"Equilibrium and Meltdown"

George Waters of Illinois State University on the economic crisis and the state of macroeconomics:

Equilibrium and Meltdown, by George A. Waters: Equilibrium in economics is such a ubiquitous concept some might be surprised to hear that it is also controversial. It is hard to imagine doing much economic analysis without examining the intersection of supply and demand, but whether we should focus exclusively on equilibrium outcomes is a critical question. Though the importance of equilibrium might seem like an esoteric debate, the attitude toward this question has deep implications for economists' views on the correct policy response to the current economic crisis.

Milton Friedman believed in equilibrium. An example of the intensity of his belief was his argument against requiring medical licenses for doctors on the grounds that more doctors would be allowed to practice, and market forces would weed out poor doctors and improve the quality of care. This argument makes perfect sense if we focus on the equilibrium outcome, but most people are instinctively repelled by this proposal. The concern arises from the consideration of how the world gets to such an equilibrium. To find out who the bad doctors are, some patients have to try them, get bad treatment and tell others about it. Since patients have little expertise in making judgments about doctors, a poor doctor could practice for many years without detection. I know this happens even with licensing requirements, but the situation could easily be worse without them. An equilibrium outcome cannot be divorced from the path to arrive at that state.

This issue arises in the labor market, with implications for macroeconomics. If labor supply always equals labor demand then there is no such thing as involuntary unemployment. Workers don't work because the wage offered is too low. While undoubtedly true for some, the picture of unemployment must be more complex. Real Business Cycle (RBC) models of the macro-economy focus on equilibrium in the labor market, leading to the remark that, in such a framework, the Great Depression was really the Great Vacation. There are other views of the labor market in macroeconomics. Traditional Keynesian approaches focus on sticky wages (and prices) and have a more natural explanation for unemployment. For example, in a recession firms prefer to use layoffs rather than lower wages. Labor search explicitly model the matching of unemployed workers and vacant positions.

Dynamic Stochastic General Equilibrium (DSGE) models are currently the dominant approach in macroeconomics. They are descendents of RBC models in that they are general equilibrium models with microfoundations, meaning they focus on household and firm behavior rather that make direct assumptions about the relationships between macro variables. However, the DSGE label applies to wide variety of models including monetary policy models with price and wage stickiness. However, the vast majority of DSGE models used for policy analysis still study fluctuations around a unique equilibrium[1].

The desirability of fiscal stimulus in response to the current crises has been a point of contention producing much debate and, unfortunately, a number of muddled arguments[2]. One notable exception comes from James Hamilton[3]who points out that the housing, financial and auto industries are going through necessary contractions, and the process of those workers finding new jobs, which could require retraining and relocating, will be a long, painful process that no fiscal or monetary stimulus can alleviate. He goes on to add that government spending that increases productivity, such as infrastructure improvements, or maintains services, such as block grants to states, could still be beneficial. I would add that spending to stimulate demand and prevent unnecessary contraction of healthy industries could help as well. Nevertheless, his point that the government should allow the labor market to adjust and not try to guarantee a certain level of employment at all times is very much on target.

Of course, fiscal policy should not be considered in isolation from other aspects of the economic crisis. The housing market continues to fall affecting households and putting the financial sector is in danger of collapse with serious effects on the economy, pushing real estate prices further still. Monetary policy has reached the zero lower bound for the Federal Funds rate, raising the possibility of a deflationary spiral. Whether to Fed can avoid such a liquidity trap with "quantitative easing," is another important issue. Targeting longer maturity rates, now that the fed funds rate is essentially fixed, is an untried idea, so far.

And what does macroeconomic theory have to tell us about the present situation? As a macroeconomist, I'm sorry to say, not enough to give confident answers to the policy questions, though we do have some helpful tools at our disposal. Labor search models have the potential to analyze the frictional unemployment that Hamilton says should be tolerated. Natural ways to describe the deflation that can arise in a liquidity trap include have been developed using a model with multiple equilibria or at least entertaining the possibility that the economy is not in equilibrium for significant periods of time[4]. Furthermore, one can think of recessions in general and financial crises in particular as shifts between multiple equilibria. However, standard DSGE models with monetary and fiscal policy are single equilibrium models and do not incorporate these possibilities. When Tom Sargent, one of the godfathers of the DSGE approach, says that "the calculations that I have seen supporting the stimulus package are back-of-the-envelope ones that ignore what we have learned in the last 60 years of macroeconomic research," he may be right in a narrow sense, but his comment is more indicative of how far macroeconomic theory has to go to properly analyze complex economic environments such as the one we face.

To be more specific, we would like to know what combination of fiscal and monetary policy can avoid deflation, maintain aggregate demand so that firms do not fail unnecessarily while allowing for necessary adjustments in the labor market. To analyze such questions, we need a model incorporating fiscal and monetary policy, a financial sector, labor search while allowing for alternate equilibria or out-or-equilibrium behavior that can be interpreted as a deflationary liquidity trap and/or a recessionary state. Many macroeconomists would disagree with the details of this prescription, but most know that a model with sufficient sophistication to give a confident policy recommendation does not exist. That back-of-the-envelope calculations are all we have should not be surprising. In Keynes' words, macroeconomists should be humble.

We can better understand economists' responses to the stimulus question through the lens of their preferred models. Those who have spent their careers working with single equilibrium RBC models tend to view the stimulus as wasteful, contributing only to debt and inflation but not productivity. Those who view unemployment as unused resources in an out of equilibrium labor market believe government spending could put those resources to work. Paul Krugman has advocated forcefully for the stimulus, which is unsurprising given the nature of his research. One of his major contributions is to show how multiple equilibria can arise in a model of international trade where industries have increasing returns to scale. The notion of an economy shifting to a better equilibrium with a push, like a stimulus, is natural for him.

One reason models with multiple equilibria are not standard parts of policy analysis is that their implications for data analysis are difficult to interpret. Interestingly, the most common macro-econometric methods that does allow for multiple equilibria is the regime shifting model of James Hamilton, which estimates a probability of switching in or out of a recessionary state in each time period. As noted above, he has expressed some skepticism about the stimulus. I suspect that he considers the current recession as a persistent change in our natural rate of growth or as necessary "creative destruction." Alternatively, the economy could be in the process of shifting to a new state with high saving, low consumption, investment and employment. Olivier Blanchard describes the crisis in these terms and advocates for policy to reinvigorate demand to help the economy to shift back[5]. Distinguishing between a temporary shift to a new equilibrium and a persistent change in productivity is hard, which points up the subtle issues arising when we take the idea of multiple states seriously.

Despite the difficulties, there is good reason to extend our understanding of models with multiple equilibria.[6] There has been some loose talk among economists that the current crisis is not a garden-variety recession. The language of multiple equilibria could help formalize this idea: Normal recessions are dips below trend for output growth that can be handled with monetary policy, but we are experiencing a potential shift to a bad state that should be avoided using all available policy tools. If the keys are not to be found under the streetlight of a unique equilibrium, we must look in the dark alley. The restriction to a unique equilibrium is not the only problematic feature of many macro models. Most micro-founded models have representative agents[7], such as a single household representing the consumption, saving and labor supply decisions for the whole economy. A quick glance out most windows reveals that not all households are the same. The vast majority also assume rational expectations, which assumes all economic actors use all available information to form forecasts, a rather strong assumption.

It is not necessary to resort to arguments based on multiple equilibria to argue for the stimulus. Standard Keynesian arguments support government expenditure to employ unused resources. Some argue against spending on the grounds that government debt will grow unsustainably. Rising national debt is a serious concern, but a temporary stimulus need not lead to an insoluble problem.

This essay is not an argument for throwing all of macroeconomic theory overboard. Understanding each of the models described above gives insights into particular issues. My primary point is that many of the arguments dismissing fiscal stimulus as a solution to the current crisis rely on strong underlying assumptions about equilibrium and the impact of government spending. Arguments against the stimulus due to concerns about the debt and the necessity of large labor and financial market adjustments are quite valid. The policy problem comes down to a difficult judgment weighing these costs against the ability of fiscal and/or monetary policy to halt a deepening of the crisis. Given the state of theory, it is not surprising that there are vast disagreements among our most eminent economists. Those who believe there is a clear answer to the question of whether fiscal stimulus will work (whatever that means) should recognize that macroeconomics needs to re-examine its most closely held beliefs.


1 In the discussion of macroeconomic models, "multiple steady states" is more accurate than "multiple equilibria" which could also encompass sunspot equilibria arising in indeterminate models. I refrain from using "steady state" to avoid excessive jargon.

2 The "treasury view" and complete crowding out arguments against the stimulus are prominent examples.

3 See his Econbrowser post "The Paradox of Thrift" of February 8, 2009. Unfortunately, he followed this with post titled "How Much is a Trillion" (March 3, 2009), which offers as much insight as the title suggests.

4 Bullard and Cho (Journal of Economic Dynamics and Control v. 29(11) and Evans, Guse and Honkapohja (European Economic Review v. 52(8) examine liquidity traps as distinct steady states. The latter argues for fiscal stimulus when monetary policy has reached the zero lower bound of its interest rate target.

5 See his Economic Focus column in The Economist (January 29, 2009). He does not explicitly talk about multiple states.

6 The idea of multiple equilibria or steady states is far from new. Cooper and John (Quarterly Journal of Economics 103 (August, 1988)) discuss a switch to an inferior steady state as a "coordination failure."

7 Peter Diamond, among others, has cautioned against relying on representative agent models for policy analysis.

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