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What a difference a decade makes.

Bullish It

OK, so I decided to do a substantive post – something I haven’t done in a while because this blog has fallen into the category where, if I have the time and energy to do this, then I also have the time and energy to do something more useful, so the only times I would be inclined to post are when I’m too busy or tired to do so. But OK, let’s say that this is useful sort of the way it was useful for my old roommate to fly back to England now and then so that he could maintain residency. After all, it seemed earlier today that Google might have revoked my visa. (For now I’ll table the question of whether the benefits of being a Blogger resident are comparable to those of being a UK resident.)

So, as the first word of the title suggests, I’m fairly optimistic about the US economy right now – where “optimistic” means I think there’s a genuine recovery going on and that it is likely to continue for at least several more months, not that I think things are going well in an absolute sense. (I mean, does anyone think things are going well in an absolute sense?) So I am more of a Smithian than a Smithist.

But another post to which I was referred by the Bearish Smith’s blog leads me to think about the issue of macroeconomics as a field. It seems (especially from the comment thread) that the Old Keynesians and the New Monetarists are at each other’s throats (but, interestingly, the newly christened Market Monetarists – who have some claim to being the legitimate intellectual heirs of the Old Monetarists – basically seem to be on the same side as the Old Keynesians on the major issues here; and the New Keynesians can break for either side depending on whether they’re more Keynesian or more New). Obviously I’m more sympathetic to the Old Keynesians than the New Monetarists, otherwise maybe my pseudonym would be “dsge” instead of “knzn.”

Here’s my take: to begin with, economics is basically bulls**t. I mean, it’s necessary bulls**t, sometimes even useful bulls**t, but I’m extremely skeptical of people who think economics is a science or that it could be a science. We have to make policy decisions (and investment decisions and personal consumption decisions etc.), and we have to have some basis for making them. We could just use intuition, and we often do, but it’s helpful to use logical thought and empirical data also, and systematic study using fields like economics can help us to clarify our intuition, our logical arguments, and our interpretation of the empirical data. The same way that bulls**t discussions that don’t make any pretense at being science can help.

Economics is bulls**t because it relies on the premise that human beings behave in a systematic way, and they don’t. Once you have done enough research to convince yourself that they behave in a certain way, they will change and start behaving in another way. Particularly if they read your research and realize that you’re trying to manipulate them by expecting them to continue behaving the way they have. But even if they don’t read your research, they may change the way they behave just because the zeitgeist changes – cultural sunspots, if you will.

The last paragraph may vaguely remind you of the Lucas critique. Lucas basically said that macroeconomics (as it was being practiced at the time) was bulls**t, but he held out the hope that it could receive micro-foundations that wouldn’t be bulls**t. The problem with Lucas’ argument, though, is that microeconomics is also bulls**t. And Noah Smith, writing some 36 years after the Lucas critique and observing its unwholesome results, takes it one step further by saying, if I may paraphrase, “Yes, the microeconomics upon which modern macro has now been founded is indeed bulls**t, but if we do the micro right, then we can come up with non-bulls**t macro.”

Yeah, I doubt it. Maybe we can come up with slightly better macro than what we’ve got now, but the underlying micro is never going to be right. Experimental results involving human subjects are inevitably subject to the micro version of the Lucas critique: once the results become well-known, they become part of a new environment that determines a new set of behavior. And the zeitgeist will screw with them also. And so on. And in any case, even if the results were robust, I’m skeptical that we can really build them into a macro model or that it would be worth the trouble even if we could. Economics will always be bulls**t.

Now there’s a case for doing rigorous bulls**t, at least as a potentially useful exercise. That’s what I think DSGE modeling is: it’s a potentially useful exercise in rigorous bulls**t. And I don’t begrudge the work of people like Steve Williamson: I think there's some rigorous bulls**t there that may be worth talking about. But in general, when it comes to bulls**t, there is not a monotonic relationship between rigor and usefulness. And to put all your eggs in the rigorous bulls**t basket – not only that, but in one particular type of rigorous bulls**t basket, because rigor does not live by rational equilibrium alone – is something that not even Pudd’nhead Wilson could advocate.

So I’m going to stick with sloppy Old Keynesian models as my main mode of macroeconomic analysis. They’re bulls**t. They’re not rigorous bulls**t. But as bulls**t goes, they’re pretty useful. A lot more useful than unaided intuition. And they’re easy enough to understand that we can have a reasonable idea of where their unrealistic assumptions are likely to lead us astray. Of course all economic models have unrealistic assumptions, but hopefully our intuition allows us to correct for that condition when applying the models to the real world. If the model is too complicated for the typical economist to understand how the assumptions generate the conclusions, then the unrealism becomes a real problem.

UPDATE: At the risk of making him guilty by association, I want to point to a post by Chris Dillow, where he makes a related point that is perhaps the point I would have tried to make if I had been in a less obnoxious mood.

UPDATE2: Noah Smith replies, defending economics as being (at least potentially) scientific. I'll concede that economics can have scientific elements (as, indeed, politics or warfare can have scientific elements), but I think those elements will always be relatively small and unimportant, whereas bulls**t will always be critical to the field.

My Blog Seems to Have Disappeared

But then why is it letting me make this post?

UPDATE: OK, it seems to have reappeared. Maybe Google temporarily "deleted" it because I hadn't logged in since they changed their privacy policy? Or maybe they are in the process of deleting it and some things are still cached? Or maybe it was just a temporary software error, and the blog was never really deleted?

Does this blog still work?

It certainly seems to be functioning as an effective spam collector.

Maybe I should actually try posting something again.

Satan and the G-16: A Sacrilegious Rant and a (Modest?) Proposal

It appears now that the G-20 intend to make their compromise with the devil. That’s pretty much inevitable, since the devil is one of them. When I say the devil, I am of course referring to the nation that invented the automobile (hint, President Obama: not the US). It also happens to be the nation that invented chemical warfare and the Final Solution. (What kind of a rant would this be if I respected Godwin’s Law?) I curse Comrade Gorbachev for countenancing the demolition of the Berlin wall. It is clear now that, despite having repented, with apparent sincerity, of its earlier sins, Germany is fundamentally evil. And right now I’m imagining Angela Merkel with horns and a pitchfork.

The devil, as I said, is one of them. It might be more accurate to say that the devil is four of them. Euroland, which is counted independently as one of the G-20, is entirely under the sway of the forces of darkness. France and Italy sold their souls long ago and have little chance of redemption. If I had my way, the remainder – call them the G-16 – would redeem their own souls and let continental Europe perish in fire and brimstone.

I would have the G-16 agree on a set of fixed exchange rates against the Euro. (And if China wants a cheap Yuan, I say, so be it. Let’s see how long it takes Premier Wen to figure out that he doesn’t have luxury of mistrusting US assets.) With interest rates at or near zero, the alternative to a fixed exchange rate regime among the G-16 is a regime of pointless competitive devaluation – much like the mercantilism of olden time. Nobody wins that way. Fixed exchange rates are the way to go, and while we’re at it, we can solve the “N-th country problem” by making Euroland the N-th country. Making Euroland the N-th country on more than generous terms of exchange. Indeed, let us say more than more than generous terms.

Yes, if the Europeans want a hard currency, let them have it. Let them have a currency so hard it will break their skulls. It’s a policy once known as “beggar thy neighbor,” and our neighbors between the Mediterranean and the North Sea are begging to be beggared.

But Keynes did die for everyone’s sins, and I suggest we hold out an offer of redemption to any European country that will repent and accept John Maynard as its personal savior. Set a (temptingly ungenerous) exchange rate against the Euro for each of the individual European currencies, and agree to collectively continue defending that exchange rate for, say, 7 years, if the sinner will stop worshiping the Golden Calf.

I remember with fondness the French Franc and the Italian Lira. I remember the picturesque bills. I remember (indeed, I have preserved some relics) the varied and beautiful coins. I remember, as recently as 2002, going to a grocery store in Spain, wondering why the prices looked so high, and realizing that the prices were in pesetas rather than euro cents. I remember. I remember the Garden.

Lost. It is lost. Shall not we assert the faith that it may be regained?

Even Worse than Paul Krugman Imagines?

Reading Karl Smith’s comment on my previous entry, I started to think about the implications of rational expectations in the context of potential deflation. I’m thinking of a model like “Rational Expectations meets Calvo Pricing meets the Keynesian Multiplier meets the Mundell-Tobin Effect.” It goes something like this:

Start out imagining that prices are stable. Then introduce the expectation of an output gap (like the output gap that the CBO expects). An output gap implies that actual (sticky) prices are above equilibrium (flexible) prices. As more cohorts adjust their prices toward equilibrium levels, actual prices will fall. If you expect actual prices to fall, you have a disincentive from investing, because you have to pay today’s sticky prices for your capital goods, but you will only be able to sell your product at tomorrow’s (lower) flexible prices. So investment will be lower than it otherwise would be. And because of the multiplier effect, consumption will be lower than it otherwise would be.

So overall demand will be significantly lower than it otherwise would be. Therefore equilibrium prices will be even lower. Therefore we have to anticipate an even greater rate of deflation. Therefore we have to anticipate an even larger disincentive from investment, which implies an even lower level of investment, which implies an even lower level of consumption, which implies even less demand, which implies even lower equilibrium prices, which implies even faster deflation, which implies an even greater disincentive from investment, and so on. And all the “so on” is something that, if we have rational expectations, we will immediately anticipate.

Without actually writing down a model (which I’m not going to do), I can’t say for sure whether there will be an equilibrium, but if there is one, I’m pretty sure it is really, really, really ugly. My intuition says that, in an economy without a public sector or a foreign sector, there will normally be no equilibrium, and all production will simply cease.

If you throw in a government, then you can presumably have an equilibrium even without any private investment, so the economy won’t grind completely to a halt, but it will sure look pretty awful. Although I wonder: if the process of selling requires holding inventories, then it requires some investment. (Technically, it requires a level of investment that may not be positive but that can still be reduced if there are incentives to reduce it.) If the disincentive to investment rises without bound, then there will be no incentive to hold inventories, and production will still cease, even with public sector demand.

I would guess that someone has already done this sort of model more rigorously, and I don’t know what the conclusions were. But I would guess that they were quite unpleasant.

What happens to the inflation when the output gap is zero?

In a blog post a couple of weeks ago, Paul Krugman presents a scatterplot of the change in the inflation rate (y) as a function of the output gap (x), with the following regression line:

y = 0.5228 x - 0.4739

I'm puzzled as to why he includes a constant term in this regression. (Maybe he was using graphics software that won't do a no-constant fit?) If you take the regression line at face value, it means that the inflation rate is predicted to fall by almost half a percentage point each year when the output gap is zero. It also means that the economy must run nearly a full percentage point above potential in order to prevent the inflation rate from falling. That doesn't make any sense.

The sensible way to do the fit is to constrain the constant term to zero (which makes the math a lot easier if you're doing the fit by hand, but some software insists on doing things the hard way even when it doesn't make sense).

It turns out it doesn't make much difference in the conclusion: the slope of the line is still approximately 0.5, and in the relevant region (with output gap above 6 percent) the intercept is not of much relative consequence. But I would have found the whole thing more convincing if the plot had displayed a reasonable regression line to begin with. When you show a line that implies that the inflation rate declines even under normal conditions, it's not that impressive when you conclude that it will decline too much under unusual conditions.


UPDATE: Paul Krugman responds. His main point is that the IMF's definition of potential output doesn't require that the inflation rate be constant when actual output equals potential (i.e. when the gap is zero). So now I understand that the IMF's construction doesn't have that property. But I'm having trouble understanding the theoretical meaning of that construction. Doesn't the IMF's filter amount to an empirical way of making a guess at a concept that still should have that property theoretically?

I suppose I can understand that you don't want to force a constraint on the guess after it has already been made. (See Prof. Kurgman's point about circular reasoning.) But the chart still doesn't look right to me. Since the CBO's potential output concept does imply stable inflation at the zero point, how can you plug the CBO's gap forecast into the IMF's gap equation and get a meaningful result? (Well, OK, the result is meaningful for our purposes, because the fitted line passes close enough to the origin to give approximately the right result, to at least the level of precision necessary for the original point about deflation risk, and because the two methods for estimating the output gap lead to reasonably similar results for the US historically -- again, given that we don't really need much precision.) Under the circumstances, since we're mixing two different concepts anyhow, it's an arbitrary decision whether to impose the zero constraint, and I think the chart would look prettier if the line went through the origin. (I suppose that's a matter of personal taste.)

I also don't like the idea of using a filter that needs to know the whole series before it can do the smoothing (which IIRC is the case with the Hodrick-Prescott filter used by the IMF). It seems to me there is still a bit of circular reasoning involved, or at least, that you're constructing a fake data series that can't necessarily be expected to have the same properties in real time as it does with benefit of hindsight. I suppose if I were doing this, and if I wanted to keep the T's crossed &c., I would avoid the CBO's gap forecasts entirely and just use raw GDP. Then I could determine historical potential output by putting the data through a one-directional filter which I could then apply to the CBO's forecasts. But it's still unclear whether the fitted line should be constrained to have a zero intercept. It seems to me, the only reason to interpret the fitted relationship as a structural one is that we have a theory wherein such a relationship exists. And in the theory, as I understand it, the line does have to pass through the origin.

Pork is Essential for Good Health

Yeah, it's not just "good for you"

Here's how things stand: the stimulus bill is way too small, it's floundering in the Senate, and we stand possibly on the edge of a deflationary abyss.

Solution: find, say, the 5 most wavering Republican senators and offer them each $100 billion worth of pork. (2 isn't enough because 1 or 2 might defect and some Democrats might defect also -- although it's kind of hard to imagine a Democrat joining a Republican filibuster under the circumstances),

That solves both problems: the stimulus bill will be big enough (if perhaps less evenly distributed in its impact than one might hope -- but multiplier effects will spread out over space), and it will survive a cloture vote.

Problem solved. No depression. Happy days are here again.

Of course, it ain't gonna happen, so I still like long Treasuries.

Time for a Price Level Target, and a Damned High One!

If you believe in a NAIRU, or anything remotely like a NAIRU or an accelerationist Phillips curve, the prognosis for prices is looking increasingly ugly. For those who believe confidently in such a Phillips curve and accept historical estimates of the parameters, deflation is now a certainty, and severe deflation is a strong possibility. Even among those who don't believe in a Phillips curve, deflation should be considered at least a serious possibility, and the danger of a deflationary spiral should not be ignored.

It's time to stop worrying about policies that "may cause inflation in the long run" and to embrace such policies specifically because they may -- and hopefully will -- cause inflation. Markets are desperately in need of "shock and awe," and the Fed can provide that shock by setting a long-run price level target much higher than anything previously considered reasonable. I would recommend a target representing an average rate of inflation of 6% over the next 5 years and 5% over the subsequent 5 years. The Fed could also set longer range price targets that represent lower inflation rates thereafter (assuming the earlier targets are achieved): say 4% from 2019 to 2024 and 3% thereafter. (Experience has now made clear that 2% was too low -- too close to zero -- for a long-run target during normal times.)

The point of using price level targets is that, the worse things get, the more inflation the Fed will promise for the future. And the more inflation it promises for the future (assuming markets believe those promises), the lower will be longer term real interest rates at any give level of nominal rates. If the Fed can induce such an expectation, it will then be able to provide a more dramatic stimulus at just the right time by setting real rates that are significantly negative. (If necessary, the Fed can set longer-term real rates by buying sufficient quantities of longer term securities, or by having the Treasury retire such securities.)

Again, "dangerous policies" that "may be highly inflationary in the long run" are just the policies that our leaders should be embracing at this moment, precisely because those policies may -- and hopefully will -- be inflationary in the long run. So if the Fed buys lower quality securities on which it risks having to take losses, let it say, "It is our great hope, in the event that economic weakness prevents the price level from approaching our target, that we may have the opportunity to take large losses on these securities and to make up those losses by creating more base money. Only by taking such losses can we implement the 'helicopter drop' that may be necessary." And if the Fed should expand the monetary base dramatically in the hope of encouraging bank lending, and detractors should argue that this policy is reckless because the Fed will need to withdraw that money later to prevent inflation and may not be willing to do so, let the Fed respond, "It is not our intention to withdraw that money later, unless the price level should threaten to rise significantly above our target. Should the inflation rate over the next few years prove too low, it is our intention to resist steadfastly any pressure to avoid the very high inflation rates that will then be necessary to achieve our target."

Let's be quite clear about the arithmetic here. If the average inflation rate over the next 5 years should be zero -- which in the absence of policies such as those I advocate above, would be a very reasonable forecast, and in the presence of such policies would still not be an unreasonable one -- the Fed will of course miss its 5-year target by a dramatic margin. But the 10-year target will remain. The arithmetic would then require an 11% inflation rate over those next 5 years, in order to meet that target. That is the promise that the Fed must make for the future in order to achieve the vital goal of producing very low real interest rates today. And as for those who say that 11% is too much, even if they be 99% of the population, to my mind they are all traitors, enemies of the United States and of the world, and if I had my way, they would all be hanged!

Their intentions are good, perhaps, but we must not let such foolishness lead us down the road to Hell.

Irrational Policy

Following up on my last post concerning Nick Rowe's application of rational expectations to public policy: it occurs to me that the way to look for evidence of policy effectiveness is to find cases where policy was, in retrospect, irrational. In other words, look for cases where policymakers were trying to achieve objectives that, in the light of later economic thought, were bad ideas in the first place. Then look at whether they succeeded in achieving those objectives.

How exactly one would go about this econometrically I have no idea, but there is at least one obvious case study, which (if you're a macroeconomist) you have probably already thought of. According to the popular story (which I'm not entirely sure is true), the boom of the late 1960's was partly a deliberate result of policy. Today's economists tend to see such booms as a bad idea, because booms (so today's theory teaches) ratchet up inflation expectations. But the concept of ratcheting up inflation expectations was virtually unknown in the 1960's. So by today's standards, the policies of the 1960's were irrational. If you believe that story, then it is at least one data point in support of the hypothesis that policy is effective.

Rational Policy

Why is it that so many economists assume that private agents are rational but policymakers are irrational?

Breaking with that rather silly custom, Nick Rowe (hat tip: Mark Thoma) applies the rational expectations concept to policymakers and reaches the conclusion that we will never be able to find evidence of policy effectiveness, even if policies are actually quite effective.

One way to think about it, perhaps, is that all we observe in the data are the effects of policy mistakes. We cannot observe policy successes because they are negative events -- non-recession, non-inflation, etc. Only if policymakers were irrational would their "successes" -- the success of perverse policies at producing perverse effects -- correspond to positive events like recessions and inflation, so that we could find correlations between policy measures and outcomes.

To be more precise, any unusual events (recessions, inflations, etc.) that we see in the data must have been unpredictable; otherwise policymakers would have predicted and avoided them. But if they were unpredictable, that means they couldn't have been correlated with any variable that is supposed to measure policy; otherwise policymakers could have observed that variable and predicted and avoided the unusual event.

I made a similar point a couple of years ago: the inability of economists to forecast recessions is actually a point in favor of the economics profession, because it means that economists who guide public policy are doing their job well and avoiding all the predictable recessions.

Snarking Bloomberg

A headline on Bloomberg:

Fed Loans Guided by Raters Grading Subprime Debt AAA

Oh, my God! You mean the Fed is actually relying on ratings provided by major ratings agencies? Can you imagine such a thing? And did you know there are homosexuals in Iran? Shocking, isn't it? Hard to believe, but it's true.

Seriously, dude, this is not news! It would be fine if you labeled it as commentary and called it something like, "Why is the Fed Relying on Raters Who Graded Subprime Debt AAA?" There is a good case to be made that the Fed should be doing its own credit research rather than relying on agencies that have both conflicts of interest and abysmal recent records. And someone else can perhaps counterargue about the dangers of allowing public institutions to pick private sector winners. Whatever. It's all very interesting, but it's not news.

Krugman on Steinbrueck

If I were a currency trader, I'd be selling Euros.