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September 13, 2011

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"Tankers and Bankers"

Posted: 12 Sep 2011 11:07 PM PDT

Jeff Ely:

Tankers and Bankers, by Jeff Ely, Cheap Talk: In the movie Inside Job, George Soros makes an analogy that made an impression on me. He talks about how oil tankers have partitions in their hulls with their oil divided across the compartments. That way when the seas are rough the oil sloshes around within its own restricted space rather than the entire cargo splashing forward and back the full length of the ship, as would happen if there were no partitions. This obviously makes the tanker more stable.
The analogy is to financial markets and regulation. Erecting partitions to make the market less liquid should improve stability. At first you say, oh that's a nice piece of rhetoric but financial markets aren't anything like oil tankers. At least I said that.
But let's ... analyze the partitioned tanker ... in the same way we would use equilibrium theory to analyze a market. ... There is a shock (rough seas) and the oil starts to spill to one end of the boat. But the partition stops the oil from going where it wants to go. There is a friction in the market. The oil in one compartment and the empty space in the adjacent compartment want to make a voluntary exchange. And it would be Pareto improving (otherwise they wouldn't want to do it.) But that partition is stopping them. This is welfare-reducing.
Moreover, there is a powerful incentive for arbitrage. Any small leak in the partition would allow equilibrium to be reached by removing the friction, allowing the oil to go where it wants to go... That must be welfare-improving.
If you think about it, market models pretty much stop there. Pareto improving trades should and do happen. Financial innovation brings down those partitions and that's good. What is almost always missing is any way of talking about the hard-to-define but clearly very real externality that is the effect of these trades on the stability of the system as a whole. That's about process and transitional dynamics, not about equilibrium.
Indeed, in equilibrium the oil in the tanker is in the same place whether or not the partitions are there.

You could also have state dependent regulation -- partitions that drop down just before the seas get rough -- and financial market participants prefer this because it eases the regulations when things are calm. But this approaches requires the ability to forecast the storm before it hits, and the recent crisis showed that we shouldn't depend upon our ability to do that.

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Posted: 12 Sep 2011 10:40 PM PDT

New Old Keynesians?

Posted: 12 Sep 2011 09:27 AM PDT

Tyler Cowen uses the term "New Old Keynesian" to describe "Paul Krugman, Brad DeLong, Justin Wolfers and others." I don't know if I am part of the "and others" or not, but in any case I resist a being assigned a particular label.

Why? Because I believe the model we use depends upon the questions we ask (this is a point emphasized by Peter Diamond at the recent Nobel Meetings in Lindau, Germany, and echoed by other speakers who followed him). If I want to know how monetary authorities should respond to relatively mild shocks in the presence of price rigidities, the standard New Keynesian model is a good choice. But if I want to understand the implications of a breakdown in financial intermediation and the possible policy responses to it, those models aren'ta very informative. They weren't built to answer this question (some variations do get at this, but not in a fully satisfactory way).

Here's a discussion of this point from a post written two years ago:

There is no grand, unifying theoretical structure in economics. We do not have one model that rules them all. Instead, what we have are models that are good at answering some questions - the ones they were built to answer - and not so good at answering others.

If I want to think about inflation in the very long run, the classical model and the quantity theory is a very good guide. But the model is not very good at looking at the short-run. For questions about how output and other variables move over the business cycle and for advice on what to do about it, I find the Keynesian model in its modern form (i.e. the New Keynesian model) to be much more informative than other models that are presently available.

But the New Keynesian model has its limits. It was built to capture "ordinary" business cycles driven by pricesluggishness of the sort that can be captured by the Calvo model model of price rigidity. The standard versions of this model do not explain how financial collapse of the type we just witnessed come about, hence they have little to say about what to do about them (which makes me suspicious of the results touted by people using multipliers derived from DSGE models based upon ordinary price rigidities). For these types of disturbances, we need some other type of model, but it is not clear what model is needed. There is no generally accepted model of financial catastrophe that captures the variety of financial market failures we have seen in the past.

But what model do we use? Do we go back to old Keynes, to the 1978 model that Robert Gordon likes, do we take some of the variations of the New Keynesian model that include effects such as financial accelerators and try to enhance those, is that the right direction to proceed? Are the Austrians right? Do we focus on Minsky? Or do we need a model that we haven't discovered yet?

We don't know, and until we do, I will continue to use the model I think gives the best answer to the question being asked. The reason that many of us looked backward for a model to help us understand the present crisis is that none of the current models were capable of explaining what we were going through. The models were largely constructed to analyze policy is the context of a Great Moderation, i.e. within a fairly stable environment. They had little to say about financial meltdown. My first reaction was to ask if the New Keynesian model had any derivative forms that would allow us to gain insight into the crisis and what to do about it and, while there were some attempts in that direction, the work was somewhat isolated and had not gone through the type of thorough analysis needed to develop robust policy prescriptions. There was something to learn from these models, but they really weren't up to the task of delivering specific answers. That may come, but we aren't there yet.

So, if nothing in the present is adequate, you begin to look to the past. The Keynesian model was constructed to look at exactly the kinds of questions we needed to answer, and as long as you are aware of the limitations of this framework - the ones that modern theory has discovered - it does provide you with a means of thinking about how economies operate when they are running at less than full employment. This model had already worried about fiscal policy at the zero interest rate bound, it had already thought about Says law, the paradox of thrift, monetary versus fiscal policy, changing interest and investment elasticities in a  crisis, etc., etc., etc. We were in the middle of a crisis and didn't have time to wait for new theory to be developed, we needed answers, answers that the elegant models that had been constructed over the last few decades simply could not provide. The Keyneisan model did provide answers. We knew the answers had limitations - we were aware of the theoretical developments in modern macro and what they implied about the old Keynesian model - but it also provided guidance at a time when guidance was needed, and it did so within a theoretical structure that was built to be useful at times like we were facing. I wish we had better answers, but we didn't, so we did the best we could. And the best we could involved at least asking what the Keynesian model would tell us, and then asking if that advice has any relevance today. Sometimes if didn't, but that was no reason to ignore the answers when it did.

[So, depending on the question being asked, I am a New Keynesian, an Old Keynesian, a Classicist, etc.]

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