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April 10, 2009

Economist's View - 6 new articles

Macroeconomic Meltdown?

The state of macroeconmics:

Are those who sweat the big stuff in meltdown?, by Tim Harford, Commentary, Financial Times: ...I am struck by the soul-searching that has gripped the [macroeconomics] profession in the face of the economic crisis. The worry is not so much that macroeconomists did not forecast the problem – bad forecasts are more a sign of a complex world than intellectual bankruptcy – but that macroeconomics seems unable to provide answers. Sometimes it cannot even ask the right questions.

Willem Buiter ... complains that macroeconomists have simply discarded the difficult stuff to make their models more elegant: "They took these non-linear stochastic dynamic general equilibrium models into the basement and beat them with a rubber hose until they behaved."

He is not alone in his frustration. Paul Krugman ... thinks macroeconomics is in a dark age, in the sense that rather than discovering new insights, we are actually going backwards and forgetting what we used to know. Mark Thoma ... opines: "I think that the current crisis has dealt a bigger blow to macroeconomic theory and modelling than many of us realise."

We shall see. While many commentators have reached for Keynes – or some caricature of Keynes – as a solution to this crisis, this is not because he is the fount of all knowledge, but because he was asking good questions about problems that now seem relevant again.

Economists now understand much more than Keynes ever could about networks and complex interactions (thanks to agent-based modelling), psychology (thanks to behavioural economics) and the real world (thanks to econometrics). In principle, these advances should inform our understanding of the crisis. An early attempt is Animal Spirits, a book by George Akerlof, a Nobel laureate, and Robert Shiller, who identified the housing bubble early. But macroeconomics has a lot of momentum and it will take time to turn the oil tanker around.

Justin Wolfers,... an unabashed microeconomist, says that, "formally elegant but empirically irrelevant macroeconomists had a much harder time getting hired this year," while Buiter reckons that the central banks have already jettisoned conventional macroeconomics in favour of a pragmatic combination of hunches and judgment calls. If so, the market for macroeconomic ideas seems to be self-correcting – much like the market for financial weapons of mass destruction. It is just a shame, in both cases, that the correction did not come more smoothly and much, much earlier.

Let me a bit more specific, and add something more to problems with macroeconomics I discussed in The Great Multiplier Debate and "The Unfortunate Uselessness of Most 'State of the Art' Academic Monetary Economics". The main mechanism generating fluctuations and policy effects in modern New Keynesian models is Calvo type sluggish price adjustment. I think this model is useful for "normal" times as a way of understanding economic fluctuations, and for learning about optimal policy, and it represents a step forward in understanding monetary policy in particular. But do people really think that all would be fine right now if prices – and they must have housing prices in mind when they think about sticky prices as an explanation for the current episode – had only adjusted faster? If housing prices had dropped even faster than they have already, all would be well in the world?

Okay, so maybe they don't have housing prices in mind. Still, do we really think that sluggish price adjustment is the main mechanism at work in the present crisis? If not, then what use is the evidence from those models? Why do we keep hearing about theoretical simulations that give values for the multiplier that are small, large, zero, less than one, whatever? Do we really think that sluggish price adjustment captures the essence of the factors driving the present crisis? I don't.

The fundamental mechanism driving the economic fluctuations is wrong, and people seem to be missing that when they try to use the evidence from this model to comment on the present situation. There are two big problems. First, we have very little data from episodes like the current one to calibrate these models. What should, say, the elasticity of labor supply be in a severe recession? Do we know? That's a key parameter in these models, and we can only guess what it's value ought to be. Second, even if we have good data from similar episodes, why run it through a model that does not capture the fundamental problem driving the downturn?

Again, I think the New Keynesian model is very useful for understanding "normal" business cycles, but I am very hesitant to use this model as the basis for policy advice in the present crisis.

So where does that leave us? We do not have either the theoretical models or the empirical evidence we need to understand this episode thoroughly and completely, and to provide the policy advice that will cure the problem with any degree of certainty. Without solid theoretical models and the associated empirical evidence, we really have no choice but to fall back upon older models that were "built to answer the questions that are important at the moment," i.e. the old-fashioned Keynesian model, and to rely upon loose, but solid theoretical principles rather than a tightly constructed model and vast amounts of empirical evidence. It's quite understandable that economists who have been striving to push the profession in a positive, scientific, solidly theoretical and evidence based direction would resist going backward, and resist strongly, but what choice do we have? Until we have a better mousetrap, the simple, old fashioned one will have to suffice.


Revisions to Payroll Employment

Payroll-adjust [months yet to be revised are omitted from source graph]

Rationality prevents us from making persistent, one-sided estimation and forecasting errors.


"Neural Mechanisms of Social Influence in Consumer Decisions"

Today's seminar:

Neural Mechanisms of Social Influence in Consumer Decisions, by Gregory Berns, C. Monica Capra, Sara Moore, and Charles Noussai: Abstract It is well-known that social influences affect consumption decisions. Although a number of different mechanisms have been hypothesized, a consumer's tendency to purchase a product is influenced by the choices made by his associative reference group. Here, we use functional magnetic resonance imaging (fMRI) to elucidate the neural mechanisms associated with social influence on a common consumer good: music. We restricted our study population to adolescents between the ages of 12-17 because music is a common purchase in this age group, and it is widely believed that adolescent behavior is particularly influenced by perceptions of popularity in their reference group. Using 15-second clips of songs downloaded from MySpace, we obtained behavioral measures of preferences and neurobiological responses to the songs. The data were gathered with, and without, the popularity of the song revealed. The popularity had a significant effect on the participants' ratings of how much they liked the songs. The fMRI results showed a strong correlation between the participants' rating and activity in the caudate nucleus, a region previously implicated in reward-driven actions. The tendency to change one's evaluation of a song was correlated with activation only in the anterior insula, a region associated with physiological arousal, particularly to negative affective states. Our results suggest that a principal mechanism whereby popularity ratings affect consumer choice is through the anxiety generated by the mismatch between one's own preferences and others'. This mismatch anxiety motivates people to switch their choices in the direction of the consensus, suggesting that this is a major force behind conformity observed in music tastes in teenagers.

This may also explain why economists generally adopt the consensus forecast, and how this tendency to conform to respected opinion within the field due to "mismatch anxiety" can lead to herd-like behavior that causes us to miss things like a housing bubble. Why take the time to think hard about the problem yourself if, in the end, you are going to adopt the view of the most respected and powerful voices in the field anyway?


Paul Krugman: Making Banking Boring

Does congress have the will to pursue serious financial reform?:

Making Banking Boring, by Paul Krugman, Commentary, NY Times: Thirty-plus years ago, when I was a graduate student in economics, only the least ambitious of my classmates sought careers in the financial world. Even then, investment banks paid more than teaching or public service — but not that much more, and anyway, everyone knew that banking was, well, boring.

In the years that followed, of course, banking became anything but boring. Wheeling and dealing flourished, and pay scales in finance shot up... And we were assured that our supersized financial sector was the key to prosperity. Instead, however, finance turned into the monster that ate the world economy. ...

Thomas Philippon and Ariell Reshef ... show that banking in America has gone through three eras over the past century. Before 1930, banking was an exciting industry featuring a number of larger-than-life figures, who built giant financial empires (some ... based on fraud). This highflying finance sector presided over a rapid increase in debt: Household debt as a percentage of G.D.P. almost doubled between World War I and 1929.

During this first era of high finance, bankers were, on average, paid much more than their counterparts in other industries. But finance lost its glamour when the banking system collapsed during the Great Depression.

The banking industry that emerged from that collapse was tightly regulated, far less colorful than it had been before the Depression, and far less lucrative.... Banking became boring, partly because bankers were so conservative about lending: Household debt ... stayed far below pre-1930s levels.

Strange to say, this era of boring banking was also an era of spectacular economic progress for most Americans.

After 1980, however, as the political winds shifted, many of the regulations on banks were lifted — and banking became exciting again. Debt began rising rapidly, eventually reaching just about the same level relative to G.D.P. as in 1929. And the financial industry exploded in size. By the middle of this decade, it accounted for a third of corporate profits.

As these changes took place, finance again became a high-paying career... Indeed, soaring incomes in finance played a large role in creating America's second Gilded Age. Needless to say, the new superstars believed that they had earned their wealth. ... And many economists agreed.

Only a few people warned that this supercharged financial system might come to a bad end. Perhaps the most notable Cassandra was Raghuram Rajan... But other[s]..., including Lawrence Summers..., ridiculed Mr. Rajan's concerns.

And the meltdown came.

Much of the seeming success of the financial industry has now been revealed as an illusion. ... Worse yet, the collapse of the financial house of cards has wreaked havoc with the rest of the economy, with world trade and industrial output actually falling faster than they did in the Great Depression. And the catastrophe has led to calls for much more regulation of the financial industry.

But my sense is that policy makers are still thinking mainly about rearranging the boxes on the bank supervisory organization chart. They're not at all ready to do what needs to be done — which is to make banking boring again.

Part of the problem is that boring banking would mean poorer bankers, and the financial industry still has a lot of friends in high places. But it's also a matter of ideology: Despite everything that has happened, most people in positions of power still associate fancy finance with economic progress.

Can they be persuaded otherwise? Will we find the will to pursue serious financial reform? If not, the current crisis won't be a one-time event; it will be the shape of things to come.


Using Inheritance Taxes to Promote Equal Opportunity

Michael Kinsley is mystified by ten Democratic senators:

Democrats for Rich Heirs?, by Michael Kinsley, Commentary, Washington Post: ...Meanwhile, the Senate is considering what to do about the estate tax. It is scheduled to be abolished next year, in one of several landmines the Bush administration set to go off after it left town. Obama proposes to reinstate the tax, at a 45 percent rate, on estates worth more than $3.5 million. Since there's no tax on what you leave to your spouse, married couples could pass on $7 million before needing to pay a dollar -- or needing to consult a lawyer who can use loopholes to save millions more.

The House has passed this measure as part of the budget. In the Senate, there's trouble. Ten Democrats have joined the Republicans in calling for a $10 million exclusion and a 35 percent rate. This is amazing. The number of people who leave estates of even $7 million is minuscule. The number leaving more than $10 million is smaller still. Yet to save these very few very wealthy people a small fraction of their estates, these senators are willing to hand their party's president an embarrassing defeat. Why on earth?

Oh, small business blah blah blah. ... To be affected by the estate tax, a business must be owned by someone of large means: at least $7 million. ...

But why the populist fury over those AIG bonuses of a few million dollars while no one seems to care much about billions being transferred through inherited wealth? The obvious answer -- that there's a difference between what people do with our hard-earned money and what they do with their own hard-earned money -- isn't actually as persuasive as it seems.

Perusing the Forbes 400 list of America's richest people, it's striking how few of them made the list by building the proverbial better mousetrap. The most common route to gargantuan wealth, like the route to smaller piles, remains inheritance. ...

Dozens of Forbes 400 fortunes derive from the rising value of land or other natural resources. These businesses are fundamentally different from mousetrap building. Land does not need to become "better" to increase in value, and that value increase doesn't produce more land. Yet other fortunes depend directly on the government. The large fortunes based on health care and pharmaceuticals would not exist if not for Medicare and Medicaid. The government hands out large fortunes even more directly in forms as varied as cable-TV franchises; cellphone licenses; drilling, mining and mineral rights; minority small-business loans; and other special treatment.

Most important, every American selling anything benefits from doing so in the world's richest market. An American doctor earns many times what the same doctor would earn in, say, India. This is not because he or she works many times harder. ... It's because we are a richer society, for reasons the American doctor had nothing to do with.

The debate over whether the estate tax should start at $7 million or $10 million is largely symbolic. That makes the push by those 10 Democratic senators for the higher amount even more mysterious.

Via Brad DeLong:

Think Progress: Lincoln's $250 billion estate tax plan would cut taxes for only 60 'small businesses.': Last week, 10 Democrats in the Senate joined all 41 Republicans in voting for a $250 billion proposal to cut estate taxes... Touting the tax cut in a press release, Lincoln claimed that it was "aimed at farms and small businesses." However, according to an analysis by the Tax Policy Center, Lincoln's $250 billion proposal would save just 60 small businesses or farms from the estate tax:

An always charged issue is how the estate tax affects small farms and family-owned businesses. We estimate that under the Obama proposal, 100 family farms and businesses [a year] would owe tax.... The Lincoln-Kyl proposal would cut the number to 40.

According to the Congressional Budget Office, "almost all such estates are able to pay the tax bill without having to sell business assets."

To try to overcome the political opposition, and to try to meet a worthy goal, I would increase and broaden the tax, and then earmark the revenues specifically for programs designed to promote equal opportunity, e.g. Head Start programs, funds to allow anyone to attend the college of their choice without running up large debts, or alternatively to help to start a business, and so on. To further help with the political opposition, the collected funds, or more precisely the programs the funds support, would be made available to everyone on an equal basis.


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