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Background on "fresh water" and "salt water" macroeconomics

by Robert

Will Wilkinson asks what’s with the economics profession.

A bit more on the public relations quandary the economics profession ought to be in, if it isn’t already…

When I see DeLong more or less indiscriminately trashing everyone at Chicago, or Krugman trashing Barro, etc., what doesn’t arise in my mind is a sense that some of these guys really know what they’re talking about while some of them are idiots. What arises in my mind is the strong suspicion that economic theory, as it is practiced and taught at the world’s leading institutions, is so far from consensus on certain fundamental questions that it is basically useless for adjudicating many profoundly important debates about economic policy. One implication of this is that it is wrong to extend to economists who advise policymakers, or become policymakers themselves, the respect we rightly extend to the practitioners of mature sciences. There is a reason extremely smart economists are out there playing reputation games instead of trying to settle the matter by doing better science. The reason is that, on the questions that are provoking intramural trashtalk, there is no science.

Sadly, there is no one better to listen to.

Now before going on I note that Wilkinson does not address the merits of DeLong’s criticisms or Krugman’s. He uses a words to suggest that they are writing unprofessionally but he doesn’t present a counter argument to their claims. I have quoted his full post. Nothing on the merits.

Instead he asks if disagreements between economists are so fundamental that there is no professional consensus useful to non economists. My brief answer is “yes.” A longer answer after the jump.

Update: Over at Kling’s blog commenter Bill Woolsey hits the nail on the head.

Perhaps part of the problem we face in macroeconomics today is that a substantial part of the “macro” wing of free market economists really think that new classical macroeconomics is “true” because simple and formalistically complete models fit their notion of what is scientific.

After the jump you can read my verbose effort to say that.

By the way, Kling’s willingness to criticize the arguments others present to support policy positions with which he agrees is really admirable.

It is like Ricardian equivalence. Because the model people (person) rationally saves to pay future taxes, we are supposed to assume this has a connection to reality?

Arnold Kling has already attempted to explain things to Wilkinson. He obtained a “department of huh?” from Brad DeLong and, for what it’s worth, two extremely intemporate comments from me (one was blocked as suspected spam because I provided to many links to support my claims which suggests something about the intellectual seriousness of comment threads at at least one blog).

While I claim that Kling’s take on the stimulus debate is absolutely inconsistent with facts in the public record which I found with a few minutes of googling, I share his general view on the divisions in the profession. He notes that there is more than one fundamental gulf which means that there isn’t a consensus among economists which would enable the few non economists who respect us to take our advice. I will mention three more just because I want to consider more economists than those discussed by Wilkensen and Kling and not because I think Kling left out anything relevant to his post

Kling discusses the policy advice of macroeconomists (and Fama). Not all economists are macroeconomists who think that it is there job to offer policy advice. He notes two divisioins left and right and fresh water and salt water.

Left and right correspond fairly closely to libertarian vs egalitarian in the US political spectrum, that is, closely to Democratic vs Republican positions on economics (except that there are leading economists well to the left of the Democratic party and well to right of all but the left fringe of the Republican party). It is a fact that, except for general support for free international trade, the range of views of economists is similar to the range of views of congressmen but somewhat broader. This is a wide enough ideological range that the methods of verification used by economists are absolutely unable to force economists on left and right to admit that economists on right and left have a point.

In the field of macroeconomics there is a much deeper division between macroeconomics as practiced at universities closer to the great lakes than to an Ocean (Fresh water economics) and that practiced at universities closer to Oceans (Salt water economics). The geography has shifted some as Fresh water economics has been exported. I’d consider Professor Robert Barro at Harvard to be brackish (with, he reports, noticed salty contamination in the first 6 months after he moved from U. Rochester) and the economics department at the University of Pompeu Fabra (in Barcelona) seems to be distilled. It is a little difficult to explain the disagreement to non economists. Frankly, I think this is because non-economists have difficulty believing that any sane person would take ffresh water economics seriously.

Roughly Fresh water economists consider general equilibrium models with complete markets and symmetric information to be decent approximations to reality. Unless they are specifically studying bounded rationality they assume rational expectations, that everyone knows and has always known every conceivable conditional probability. I’ve only met one economists who claims to believe that people actually do have rational expectations (and I suspect he was joking). However, the fresh water view is that it usually must be assumed that people have rational expectations.

Over near the Great Lakes there is considerable investigation of models in which the market outcome is Pareto efficient, that is, it is asserted that recessions are optimal and that, if they could be prevented, it would be a mistake to prevent them.

Salt water macroeconomics is basically everything else with huge differences between people who attempt to conduct useful empirical research without using formal economic theory and people who note the fundamental theoretical importance of incomplete markets and of asymmetric information and of imperfect competition (as in everything you think you know about general equilibrium theory is known to be false if markets are incomplete or there is asymmetric information or there is imperfect competition – Market outcomes are generically constrained Pareto inefficient which means that everyone can be made better off by regulations imposed by regulators who don’t know anything not known to market participants who also just restrict economic activity and don’t introduce innovations like, say, unemployment insurance).

Leading fresh water macroeconomists include Robert Lucas, Ed Prescott Thomas Sargent, Lars Hansen, John Cochrane, Larry Jones, Robert Barro (mostly), and Kevin Murphy (usually). Leading salt water economists include Paul Samuelson, Edmund Malinvaud, Jacques Dreze, Joseph Stiglitz, Robert Solow, Paul Krugman, Andrei Shliefer, Olivier Blanchard, George Akerlof, Robert Hall, Ben Bernankle, N. Gregory Mankiw, Christina Romer, David Romer and, and Lawrence Summers. Brad DeLong is also a salt water economist and he is very very smart, but last I knew, he was a little too far out there to be really a member of the economists club. I can’t classify Paul Romer.

Notably all of the above have made important contributions to fields other than macroeconomics.

In the US there is a strong correlation between Fresh and Salt and Right and Left. The correlation is not perfect: I understand that Hansen and Sargent are politically left of center. Hall is far right politically, Mankiw is right of center. and I must admit that I have no clue about Bernanke (who I have never actually, you know, seen in the flesh).

An important discrimminant is opinions of John Maynard Keynes. Fresh water macroeconomists generally seem to think that he was not a competent economist. Salt water macroeconomists claim (often implausibly) to be in some way his intellectual followers. Barro for example clearly doesn’t remember what is written in “The General Theory of Employment Interest and Money.” Mankiw, in contrast, advised the students in his macro class (including me) to read it again and again searching for insights.

Interestingly, the fresh water macroeconomists are certain that salt water macro is discredited along the lines of the Ptolomaic model or the Phlogiston hypothesis. For a while they called their models “Modern Business Cycle Theory” stating that all incompatible models were obsolete. In the current debate many have considered it sufficient to say that arguments for the stimulus are nonsense (e.g. Cochrane). The surprisingly low quality of contributions to the debate from the vicinity of Great Lakes has a lot to do with the fact that Fresh Water macroeconomists haven’t thought about fiscal stimulus in decades and sincerely believe that it is an obviously invalid proposal so obvious arguments against it might be valid.

Even more interesting, Fresh water macroeconomists do not claim that their models have not been refuted by the data. Rather they note that all models are, by definition, false. They do test hypotheses from time to time, but don’t explain what the point is. As far as I can understand, they claim that a model *can* be both false and useful and, therefore, their models *are* useful.

I understand that in the 70s and, maybe, the early 80s there was a heated debate between Fresh Water and Salt water macroecnomists. Now, it seems to me that there is a truce of sorts where each school of thought ignores the other – that macroeconomists have specialized not in the questions that they ask but in the answers.

I think that this is a very bad situation. Anyone can see that, when top macroeconomists are asked for policy advice, some support each of the different proposals which are under consideration.

Frankly, this truce seems to me to be unilateral. Many salt water economists claim (in public) to respect the contribution of fresh water economists. I know of no fresh water economist who has expressed anything but contempt for the contributions of salt water economists to the stimulus debate and I haven’t heard one word of praise of a Salt Water economist from a Fresh water macroeconomist other than Arrow, Samuelson or Solow. I added the phrase “in public” because I clearly remember one of the salt water economists on my list refer to the fresh water economists as “the crazies”.

update: The truce is over. There have been continual cease fire offensives violations, but the shrill blitzkreig is here.

As far as I can tell, fresh water economists have some respect for some thinkers other than fresh water economists. I think they have rather a favorable view of mathematicians and Physicists. I think it would be useful of mathematicians and physicists to look into fresh water macro and express an opinion. On the other hand, in principle they have great respect for general equilibrium theory, but they don’t listen to general equilibrium theorists at all. Top general equilibrium theorists are all at least left of center politically, the closest David Cass could come to naming an exception is Ed Prescott who, he said, uses general equilibrium theory and studies examples (snort).

Finally I have a view of how people can devote so much effort to working out the implications of assumptions which almost no ordinary people would find other than nonsensical if they understood them. Fresh water economics uses difficult mathematical tools. Students in fresh water graduate programs have to learn a huge amount of math very fast. It is not possible to do so if one doesn’t set aside all doubt as to the validity of the approach. Once the huge investment has been made it is psychologically difficult to decide that it was wasted. Hence the school gets new disciples by forcing students to follow extremely difficult courses. Last I hear very few graduate students at U Minnesota came from the USA. Undergrads over there know what the program is like. If my information is not out of date, innocents from abroad are the new blood of fresh water economics.

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Barro on Keynes Barro and Grossman

Robert Waldmann

Robert Barro wrote an op-ed in The Wall Street Journal. The substance of the op-ed is to report an estimate of the Fiscal multiplier 0.8 which is less than one. Thus, according to Barro, a stimulus will partially crowd out of investment, consumption or net exports and not just reduced leisure. Paul Krugman took Barro to task for using the huge WWII stimulus in his estimates, since the economy was at full employment during WWII. So have Matthew Yglesias using his Harvard BA in philosophy from Harvard and Kevin Drum using his BA in Communications from The California State University in Long Beach.

I might want to reassess Long Beach State, but I think the reason that Yglesias and Drum immediately make the same argument is Krugman is that Yglesias and Drum don’t know about modern econometrics. Barro is using an instrumental variables regression in which wartime military spending is considered to be an exogenous variable which is correlated with government consumption. The implicit assumption is that we can safely assume that the fiscal multiplier today is identical to the fiscal multiplier during World War II, because the economy is basically similar. Without training in modern econometrics it is simply impossible to assume something that stupid.

There is also a severe gap in economic theory, at least as remembered by Robert Barro. Wouldn’t one think that there must be some model in which correlations vary depending on the general conditions of the economy — say like whether at current prices there is excess demand for goods or excess supply of goods.

Of course, no one could expect Barro to know that there is a vaguely Keynesian model, which differs from the neoclassical model only because of rigid nominal wages and prices, in which the economy can be in one of three different regimes, Keynsian (with insufficient aggregate demand), Classical (firms can sell as much as they want but real wages are too high so workers are unemployed) and repressed inflation (excess supply of labor and goods).

I’m mean who’s ever heard of the Barro-Grossman model (A General Disequilibrium Model of Income and Employment Barro, Robert J.; Grossman, Herschel I.; American Economic Review, March 1971, v. 61, iss. 1, pp. 82-93 [stable JSTOR link added for those with access])? Certainly not Robert Barro.

The passage quoted by Krugman about what Keynes thought is inconsistent with The General Theory. However, it can be corrected easily. The accurate description of the history of economic thought is “John Maynard Keynes Robert Barro and Herschel Grossman thought that the problem lay with wages and prices … will mean that wages and prices do not have to fall.”

Look I sympathise. Like Barro, when I was young and reckless I did embarrassing things which I have tried to cancel from my memory. I really wish I could do that as well as he has.

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de Long is Too Kind to von Hayek

Robert Waldmann

DeLong criticizes the introduction to the second edition of “The Road to Serfdom”

On Hayek you prove that Hayek claimed that the UK was on the road to serfdom, you don’t prove that he claimed that it had gone beyond the point of no return on that road, that a U-turn before arrival at Serfdom was impossible.

Odd. Hayek definitely did claim exactly that. He was a serious thinker and felt obliged to derive a testable prediction from his hypothesis. He noted (in the original main body of the book) that he had arrived at such a prediction in conversations with friends. He did not say that Karl Popper was one of those friends but that is my (untestable) hypothesis.

So he made a prediction specifically about when the progress towards serfdom was irreversible, no turning around before gettting there. He say that point of no return was the impossition of restrictions on the expatriation of wealth. His hypothesis stands or falls on the validity of the prediction that no country can impose such controls and then turn back before reaching full serfdom.

The Atlee government imposed such controls. Actually when I moved to Italy, Italy had such controls. Either the Thatcher governments were, in Hayek’s view, an irrelevant bump in the road to serfdom, or his clearly stated prediction was refuted by the data.

I didn’t notice Hayek saying that Thatcher made no difference and that England was still as irreversibly doomed to serfdom as it was in 1946. I repeat, he was a serious thinker so, when he presented a hypothesis, he made a firm prediction. To be clearer, he was a serious thinker, in 1945, so he made a firm prediction in 1945.

Then he decided that his ideology was more precious to him than his intellectual integrity and neglected to confront his clear prediction with the facts or admit that he was wrong in 1945

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Welfare Reform "Not a Disaster" ?

Robert Waldmann

Pieter Beinart serves up some conventional wisdom in the Washington Post. Unfortunately he is totally wrong, because he hasn’t checked the facts in the past 7 years.

Beinart wrote

“Older liberals remember …. They also remember the welfare reform debate of the mid-1990s, when prominent liberals predicted disaster, and disaster didn’t happen.”

Oh didn’t it ?

Try telling it to the severely poor

Beinart is a lazy fool, as I argue after the jump.

I’m afraid Mr Beinart will be down to one example soon. The welfare reform was promptly followed by an amazing boom which no one predicted. Then he lost interest in the issue. Beinart decided that, since poor people did OK in the late 90s, welfare reform was a good idea.

What happened with welfare reform and without an extraordinary boom ? The number of Americans in “severe poverty” grew 26% from 2000 to 2005, that’s what happened. “Severe poverty” is severe, “A family of four with two children and an annual income of less than $9,903 – half the federal poverty line – was considered severely poor in 2005.”

So welfare reform worked great didn’t it ? Now one might argue that the problem was that the economy was horribly bad from 2000 to 2005 (and the comparison is with 2000 not 1996) however the 2005 severe poverty rate was the highest in 32 years including the severe recession in 1982. The immense severe poverty rate was achieved with moderate unemployment.

All data from this McClatchy article

update (link fixed thanks to kolohe)

Beinart only concludes that welfare reform wasn’t a disaster, because he only paid attention to what was happening to the poor for a few extraordinary years.

In 2000 one could argue whether the improvement in economic conditions of the US poor was due to the booming economy, due in part to the booming economy and due in part to welfare reform or more than 100% due to the booming economy which more than undid the damage of welfare reform. Now, with more data, it might still be possible to avoid reaching the third conclusion, but I haven’t read the argument. The fact, the plain simple fact, that severe poverty has increased since welfare was reformed is not mentioned in the discussion.

This is important, because the nonsensical clearly false claim made by Beinart is definitely the conventional wisdom. Notice that Obama only promised to cut the taxes of 95% of US families. The other 5% mostly weren’t those so rich that he proposed raising their taxes (that would be between 1% and 2%). They were the poorest who could only be given more money by unreforming welfare.

It is well known that welfare reform was followed by an improvement in the economic conditions of the poorest Americans. The minor fact that this is no longer true and hasn’t been true for years is not worthy of notice.

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What’s in the Water in Chicago ?

Robert Waldmann

Gary Becker writes (via Lane Kenworthy who is strangely polite in response)

As Posner and others have indicated, there appears to have been a huge conversion of economists toward Keynesian deficit spenders, but the evidence that produced such a “conversion” is not apparent (although maybe most economists were closet Keynesians all along). This is a serious recession, but Romer and Bernstein project a peak unemployment rate without the stimulus of about 9%. The 1981-82 recession had a peak unemployment rate of about 10.5%, but there was no apparent major “conversion” of economists at that time. What is so different about the present recession compared to that one, and to other recessions since then, that would greatly raise the estimated stimulating effects of government spending on various types of goods and services?

It is relevant in answering this question that the origins of this recession were in the financial sector, and especially in the excessive mortgage credit to sub prime and other borrowers. The widespread collapse of the financial sector, and the wholesale retreat from risky assets, clearly has called for a highly pro-active Fed. But it is not obvious why this should lead to greater confidence in the power of government spending stimulus packages. Of course, perhaps the prior emphasis on crowding out, and skepticism toward the stimulating effects of government spending, were wrong, or that recessions were too short and mild after the 1981-82 recession to call for Keynesian-type stimulus packages.

This is an excerpt from a longer essay, but, I think that relevant context is not removed. I don’t think that anyone can read the whole post and doubt that Becker claims that it is mysterious that fiscal policy, as opposed to monetary policy, is back in fashion now compared to 1982.

Evidently, he either doesn’t know that the target federal funds rate is “0 – 0.25” or doesn’t think that this fact is relevant to the discussion.

Is it really possible that a Nobel laureate in economics isn’t familiar with the argument that the effectiveness of monetary policy changes when a nominal interest rate reaches zero ? Is there any other explanation for why he wrote what he wrote ? Even if he were completely dishonest he can’t really hope to keep the current target federal funds rate a secret can he ?

The rest of his post is based on the argument that the market economy can’t get workers into vacant jobs in response to a shock. I don’t mean that this happens slowly or is costly, he assumes that it doesn’t happen at all (the post contains no discussion of labor market dynamics at all and doesn’t acknowledge in any way that there is any such thing).

I honestly don’t know what’s going on. I think over at U Chicago they have decided that Keynes was wrong, that what he wrote was obvious nonsense and concluded that any argument that comes to their mind must be a valid refutation of Keynes.

update: Minds think alike.

update II: My further thoughts on Krugman’s further thoughts after the jump

Update III: Minds think alike II. Now I understand. Becker was irritated that Fama was getting all the attention and decided to see how many links he could get. Looks like Fama is toast.

I think there is another contributing factor to the silliness in Chicago. The arguments for the stimulus are basically straight from Keynes. You and other supporters basically state that macroeconomics has made no progress in 70 years on how to address the current situation. Now aside from questions of left vs right, that is deeply offensive to economists in Chicago who are proud of that universities role in the rational expectations revolution.

I think that aside from hostility to public spending and to the idea that the government can improve on market outcomes there is also a deep deep hostility to Keynes, Hicks, Samuelson (the macro-economist) etc. I mean if you had a disease, and your trusted physician didn’t know what do do with it and someone argued that your 4 humors were out of balance and the solution was something that seems to have worked once in the past, how would you react ?

I think that a little voice screams “that’s nonsense” whenever they hear about “multipliers” and “fiscal stimulus.” The strangest contributions are those of Fama and Becker who aren’t macroeconomists and who are just sure that Keynes was totally wrong, don’t remember exactly why, but are sure it is something obvious.

A test case of my alternative explanation is Thomas Sargent. He is not ideologically right wing. He is definitely anti-Keynesian. IIRC his only contribution to the debate was to note that the back of the envelope calculations to be found, for example, here are based on a 71 year old model as if macroeconomists had learned nothing in the past 60 years (I don’t know where those 11 years went either). This claim is, of course, true. I don’t even know if he went on to argue against the stimulus. Your view is that Macroeconomists haven’t learned anything which is currently useful in the past 71 years, but you can see how many economists find that conclusion intolerable.

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The Effect of Government Spending on GNP in the Classical Model

Robert Waldmann

Brad DeLong has been denouncing Eugene Fama for arguing that an identity proves that the stimulus won’t work as advertised. Greg Mankiw attempts to defend Fama by arguing that Fama was assuming that the classical model, in which all markets including the labor market clear, holds. Brad DeLong notes that Fama made it very clear that he was not discussing the classical model. I don’t have much to add, but I would like to note that Fama’s argument would be false if the world corresponded to a Real Business Cycle Model — that is the only type of classical model that any economist takes seriously as a model of short term fluctuations.

Before getting to my thoughts, this post got to be very long so I am banishing all of my summary of the debate so far past the jump. Up here, just make the assumption that all markets clear so, among other things, labor demand equals labor supply and ask if Government deficit spending can cause an increase in measured GDP assuming that the product of public investment is no more productive than the products of private investment. The answer, according to the classical model is clearly yes, so Mankiw’s defence of Fama fails on its own terms even if one overlooks the fact that Fama made it perfectly clear that he wasn’t assuming that the classical model describes reality.

The model in which Fama’s conclusion would be valid is the classical model with exogenous labor supply. If capital is a state variable and labor supply is exogenous and all markets clear, then output is determined by the aggregate production function and can’t be affected by Government spending or anything else. However, the question of whether it is reasonable to assume the classical model and fixed labor supply when discussing short term fluctuations is *not* a judgment call even under Mankiw’s very broad apparent definition as an issue with prominent economists on both sides. Economists have noticed that aggregate hours worked fluctuate and that such fluctuations are correlated with other economic variables. There are, amazing but true, two schools of thought on what is going on. Some economists do indeed argue that the labor market always clears and that labor supply and demand are both fluctuating in response to other variables. Others believe that there is such a thing as unemployment. No one believes that it is a coincidence and that labor supply has nothing to do with anything else in the economy and is equal to labor demand. No one.

The classical model as it appears in current research assumes endogenous labor supply. It quickly becomes complicated, but has a clear implication that a temporary increase in wages causes an increase in labor supply (the temporary is needed to keep income effects small enough and how temporary is temporary enough depends on the shape of utility functions). In particular if the increase in wages is brief enough, the response of labor supply goes to the compensated elasticity which, according to the model must be positive. Sometimes it is assumed to be infinite. In modern market clearing macro models it is always very high.

The elasticity of labor demand is also very high in such models, but this doesn’t matter.

What happens when the government spends more ? Well to hire workers in the classical model they have to offer higher than prevailing wages. The increase in wages causes labor supply to increase and private employment to decline. Total employment increases because labor supply has increased. Assuming that public capital spending is exactly as efficient as private capital spending the capital stock is higher than it would be if the Government hadn’t invested in infrastructure.

Fama’s conclusion is false if one assumes the classical model unless one assumes that labor supply is exogenous. Now I’m sure the classical model with exogenous labor supply is exactly the classical model to which Mankiw refers. However, no economist considers it a reasonable approximation to reality.

There is an identity in macroeconomics. It says that in any given year private investment must equal the sum of private savings, corporate savings (retained earnings), and government savings (the government surplus, which is more likely negative, that is, a deficit),
PI = PS + CS + GS
(1)

In a global economy the quantities in the equation are global. This means the equation need not hold in a particular country, but it must hold in the world as a whole. For example, in recent years private investment in the US has been greater than the sum of private, corporate, and government savings in the US. This means the US has been importing savings from the rest of the world (by selling US securities to the rest of the world). But the equation always holds for the world as whole.

The quantities in the equation are not predetermined from year to year, and government actions affect them. The goal of government policy is to expand current and future incomes. When I analyze the auto bailout and the stimulus plan below, I judge them on whether they are likely to achieve this goal.

Government bailouts and stimulus plans seem attractive when there are idle resources – unemployment. Unfortunately, bailouts and stimulus plans are not a cure. The problem is simple: bailouts and stimulus plans are funded by issuing more government debt. (The money must come from somewhere!) The added debt absorbs savings that would otherwise go to private investment. In the end, despite the existence of idle resources, bailouts and stimulus plans do not add to current resources in use. They just move resources from one use to another

.

Brad now has a very readable pdf up.

N Greg. Mankiw has attempted to defend Eugene Fama writing

In the case at hand, I think Fama’s arguments make sense in the context of the classical model, the model presented in Chapter 3 of my intermediate macro textbook, even if Fama in his brief essay does not spell out all the details of that model. Unlike Fama, and like Brad, I would not stop at that model. To understand the present situation, I would go on to the Keynesian model presented in Chapter 9 to 11. But whether one leaves the classical model behind to embrace the Keynesian model is a judgment call. On this particular judgment call, Brad and I agree, but I am not eager to castigate those like Fama who reach differing judgments.

DeLong replies by noting that Fama made it perfectly clear that he was *not* talking about the classical model at all, since he assumed that there are “idle resources” which don’t exist in the classical model. Obviously he is right.

I personally am more displeased by Mankiw’s insistence that “whether one leaves the classical model behind to embrace the Keynesian model is a judgment call.” I think he means that prominent economists have made a different call than he and Brad have. I believe (I admit I base this on brief contact with Mankiw long ago) that Mankiw decides that assertions about economics are worthy of castigation or not depending on whether they have been stated by a proiminent economist (a Nobel laureate is automatically so prominent that Mankiw thinks that his views must not be castigated but I think Mankiw believes that there is a much larger set of uncastigatable economists). On the other hand, views which are not held by anyone in that club should sometimes be castigated.

Now I admit again that I am just guessing about Mankiw’s decision rule (and I admit that I have no doubt at all that my guess is correct). But if there were an agent whose decision rule was that which I ascribe to Mankiw, that agent would be a menace. The rule has nothing to do with evidence, data, or reality. It can’t have any place in any field which aims to be a science. I note that Brad didn’t use profanity or insult Fama’s character intellect or mother. He the text of Fama’s post. Only his conclusion — that Fama made an error not a judgment call — is unacceptable to Mankiw.

For completeness an edited version of my comment on Brad’s post.

Notice he didn’t say anything about the elasticity of labor supply. One can have the labor market clearing a postitive elasticity of labor supply and have Government spending drive labor supply up (above the socially optimal level). For Fama to be right one has to assume that markets clear *and* that labor supply is exogenouse, that it doesn’t depend on wges and prices. Now even using Mankiw’s definition of “judgment call” which I interpret as meaning “prominent economists make different calls,” this is just not a judgment call. People write down models with exogenous labor supply when they are focusing on long run growth, but, as far as I know, no economist has ever argued that, when discussing economic fluctuations, it is reasonable to assume both that the labor market clears and that labor supply is exogenous.

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The Big Bad Asset Bank

Robert Waldmann

Is proposing toxic sludge inc with a cooler name, while commenting on Krugman.

Krugman writes

Bad bank bafflement

The idea of setting up a “bad bank” or “aggregator bank” to take over the financial system’s troubled assets seems to be gaining steam. So let me go on record as saying that I don’t understand the proposal.

I comment.

I am a fan of the big bad asset bank and I think it can be managed without any risk of giving huge amounts away, if assets are bought with shares in the big bad asset bank (dividends from payments on the underlying assets). I thnk that all mortgage based instruments should be requisitioned for the bank (shares distributed proportional to market prices as of the day before anyone takes this idea seriously)

Now I guess that supporters of the BBAB are not interested in my proposal, since I guess that a huge giveaway is their aim. However, I don’t think that it would be a pointless exercise. If all the suspect assets are put in one entity, you can buy its shares without worrying about adverse selection. If the problem with the funny assets markets is low trading volume making the market price far below the average hold to maturity value, because of adverse selection, then this is the solution.

(Also the Big Bad Asset Bank would be able to reassemble whole mortgages and renegotiate with debtors.)

I’d say the general argument is very simple. If the problem is adverse selection, the solution is mandatory pooling. There is no need for public money.

update:

Josh Marshall and Duncan Black agree with Krugman. I do to, in a way. I agree that all existing Big Bad Asset Bank proposals are based on a desire to trick the public into giving banks money for nothing. My proposal is a way to separate any efficiency gains from pooling from that transfer. I’m sure that no one will be interested in my proposal, since the point of the proposals is to trick the public out of our money. It is a way of trying to call BBAB proponents on their hypocrisy.

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Bonaventura Anselm and Kaus

Robert Waldmann

What can we learn from really bad arguments ?

I think it is useful to examine plainly invalid arguments, because the error in thought which they grossly manifest might contaminate less obviously idiotic contributions to the discussion.

A few arguments are so dumb that they have remained fixed in my mind. Most of them are not due to Mickey Kaus, but two are. They illustrate the same fallacy. I discuss one here.

The other is Mickey Kaus’s argument that liberals should not concern themselves with inequality of income. After the jump, I will critique my recollection of this argument.

Update: I appear to have inadvertantly slandered St Bonaventura (more often spelled Bonaventure by people who don’t live in Italy) when I compared his reasoning to Kaus’s. St B might thank mALACLYPSE in comments.

IIRC Kaus argued that there is clearly an increasing trend in income inequality in developed countries. He was struck, in particular, by the fact, that inequality had increased in Sweden so the change in income inequality over the preceding 10 years had been positive in both Sweden and the USA, which have notably different approaches to dealing with inequality.

Then Kaus implicitly assumed that all positive numbers are approximately equal and concluded that the evidence proved that there was nothing much to be done about increasing income inequality and that we should just accept it as inevitable.

Anyone who reads this paper (warning pdf), must notice that the argument is, shall we say, not proven by evidence which became available after Kaus made his argument and implicit prediction. There aren’t developed countries in which inequality has declined much in recent decades, but there are developed countries in which measured inequality hasn’t increased noticeably. The increase in the USA is clearly extraordinary.

In any case, an argument based on the assumption that all positive numbers are approximately equal is worthless (note I resisted the temptation to write “approximately worthless”).

The total worthlessness of Kaus’s argument becomes, if possible, more obvious, if we consider how he might have argued if the data had been different. Equally valid (that is worthless) arguments can be made for not trying to do anything about income inequality if it is clearly trending up, clearly trending down or has no clear trend. In fact, the argument for not bothering based on the clear widespread downward trend (up until the 70’s roughly) was much more convincing that Kaus’s. If inequality in market economies trends down, then we might hope that it will more or less vanish (it can’t be less than zero). So why worry ?

The argument based on the absence of a clear trend actually has a noble pedigree. Pareto argued, based on the fact that he found no clear trend in inequality, that it is a social constant and will always be about the same. Therefore he concluded there wasn’t much point trying to do anything about it.

Now if there are three possibilities and they all imply the same highly controversial conclusion via arguments of clearly similar validity, we should guess that all three are of roughly zero validity.

The more recent example of an clearly invalid argument from Kaus, teaches us nothing new about reasoning. It just shows that Kaus still relies on the assumption that all positive numbers are approximately equal.

I haven’t actually read many arguments made by Kaus (after the first I encountered which is the one discussed above, I decided it wasn’t good for my health). So, I’ve read a few, certainly less than 10 (my honest guess is at most 3) and, it seems to me, that two of them develop the implications of the assumption that all postive numbers are approximately equal.

I conclude that Kaus really thinks that way, and sees nothing wrong with the assumption.

I am not exaggerating. This is my sincere opinion, expressed without hyperbole, and held with considerable confidence.

For another example, 30 years ago, I tried to figure out what was wrong with the ontological proof of the existence of God made by Saint Bonaventura Anselm based on a possibly unfair translation which begins with a definition of the word “God”

God n. A being more sublime than any other conceivable being.

Then proceeds to note that if God did not exist, then it would be possible to conceive of a being which had all of God’s other sublime characteristics and further more had the characteristic of “existence”. This contradicts the definition of God. Therefore God exists.

Now even assuming for the sake of argument, that God does in fact exist, there is clearly something wrong with this argument. One has to wonder whether the same thing is also wrong with arguments that have convinced one. I didn’t get very far in my effort to figure out what was wrong with the argument, but there was this guy named Willard Quine who did and wrote the arguments down in this little book “From a Logical Point of View.”

There are two problems. First, the general rule of debate is that people are allowed to define terms. At most, they may be prevented from redefining an existing word and forced to define a neologism (so Bonaventura St. Anselm would only prove the existence of the most sublime conceivable being God2 if the word “God” was taken). This general rule is no good, as definitions are not necessarily “innocent”. We can’t allow people the authority to just state a definition, because such a statement may have implications which are false. Here Bonaventura St. Anselm is defining “God” and defining “sublime” so that “existence” is one form of sublimity.

Instead, we might hope to make rules for defining terms such that only innocent definitions — definitions which can’t be false statements — are allowed. Quine’s main point (I’m told) is to conclude that this effort had failed and we’d just have to risk falling for BonaventurAnselmian arguments.

The other problem is that “existence” is not a characteristic like other characteristics. “Pegasus exists” is not a statement like “Pegasus flies.” The grammatic similarity hides a fundamental difference. Pegasus can’t fly without existing. All statements about mythical or hypothetical entities (including statements which are true by definition including uhm definitions) must be phrased in the form “if Pegasus were to exist then Pegasus would be a winged horse.” A simpler rule, which works just as well, is to require all definitions to be of that form so we can define “Life” by “If life exists it would be the notional trait shared by all things that grow and reproduce” without expressing a view as to the existence or non existence of at least one living thing.

Why that works rather well. Bonaventura would be rewritten as having proven “If God exists then God exists”.

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Optimal Fiscal Policy with a Liquidity Trap and Gridlock

Robert Waldmann

I’m still thinking about Krugman’s excellent little model which gives the very clear result that optimal macro policy implies that unemployment is always at the natural rate and so, if the nominal interest rate is zero, the optimal fiscal stimulus should drive unemployment all of the way to the natural rate.

Krugman’s model is a simple inter-temporal model with rational expectations. This means that it has the odd feature that tax cuts have no effect on demand — people rationally understand that they will have to pay for Government consumption (G) sooner or later so they don’t count the federal debt as part of their net wealth.

Government consumption can still stimulate the economy. The multiplier is exactly 1 whether it is tax financed or deficit financed (this also requires that money demand depends on private consumption, that is that the Treasury doesn’t have to keep a significant amount of money in its checking account).

The model is exactly what a model should be — it is comprehensible (to me only on a second reading the explanation is very brief) and clarifies thought. Also, of course, it is much simpler than reality.

Krugman is puzzled as to why the Obama administration in waiting proposed a much more modest stimulus. They make two arguments.

First that the President isn’t the fiscal authority — he proposes but Congress decides. Obama clearly said that he expects congress to increase spending beyond the proposal, since that is what congress usually does.

Second that a larger stimulus would burden the economy with excessive debt.

Do these arguments make any sense ? What happens when we combine them ? I present a “model” after the jump which suggests that the answer is yes.

Before deciding whether or not to take the jump, ask yourself 2 questions.

Krugman’s argument does not depend on the duration of the period of trapped liquidity. If unemployment were above the natural rate for 10 years with the nominal interest rate equal to zero, then he would recommend fiscal stimulus for 10 years. Might that lead to an unsustainable deficit and default in the future ? Would that be optimal ?

OK I will present 2 pseudo models. One is a parody of Krugman’s model which takes it a few decades back in time. It is the dear old IS-LM Phillips curve model. Here fiscal policy affects aggregate demand directly via G or indirectly via disposable income Yd = GNP minus Taxes plus Transfers = Y-T. In this case, a fiscal stimulus can be turned off and on as quickly as G and T can be changed. The model is static except for the Phillips curve so the Federal debt doesn’t matter (it doesn’t appear at all in the IS-LM model). Now this model has been out of fashion since before I took my first course in economics. However, it still affects the way people think, because it is neat and simple and you can come up with an optimizing model which is more or less the same when you have to present your reasoning. In this case, I think, the “more or less” matters a lot.

I’m going to stick to an IS-LM model except that I will change the assumptions about consumption. I’m pretty sure that Krugman can translate my argument to an argument in his model in a minute. This means I won’t do the New-Keynesian formal analysis and I will consider investment (isn’t there in Krugman’s model). Being ad hoc, I will just assume investment is a shift variable times decreasing function of the real interest rate. The crisis is a sharp decline in that shift variable. I will assume a closed economy, but I really think that doesn’t matter much.

The model of consumption is rational optimization with overlapping generations of infinite lived agents (due to O.J. Blanchard). Huh ? Let me explain. A standard macro optimizing model of consumption assumes that all consumers are rational, immortal and identical. It implies that the timing of taxes has no effect on anything (shows Ricardian equivalence). This feature is not realistic. Krugman assumes Ricardian equivalence.

A way to avoid this result is to have new agents arrive who will help repay the debt even though they didn’t benefit from the tax cuts or G increase which caused it. Say half of the debt (in present value) will be paid by people who haven’t arrived yet arrivals. This means that government bonds are net wealth for current inhabitants, not at their full market value but, on average, at half of it (the value of the bonds I own minus my share of the extra taxes to pay for them). Barro might argue that, with bequests, taxes paid by the children of the current residents count as taxes paid by current residents. Now I think he is fundmantally wrong, because I don’t think people are approximately rational. However, here and now I am assuming full rationality, so I appeal to immigrants. US residents clearly don’t care much about foreigners and about a million of them are (legally) entering the US a year and paying taxes.

OK now I assume logarithmic utility, this makes things simple, it means that optimal consumption is the rate of time preference (rho) times total wealth which consists of physical wealth plus the present discounted value of future labor income minus the present value of future tax payments. Future labor income depends on the future capital stock and on future unemployment rates, but I will mostly assume it is exogenous.

This means that consumption depends on the federal debt. It is what it would be with no federal debt + 0.5rho times the federal debt. There is an effect of fiscal policy on consumption, but it depends on the debt and not on current taxes as in the original IS-LM model.

Now Obama (and Krugman) clearly believe that, for a given path of G, a huge national debt is a bad thing in normal times, that is when unemployment is set equal to the natural rate by the FED. This means that output is the same no matter what the federal debt is. Consumption is greater if there is more debt, so investment is lower. They guess that the market is about right without distortion so the optimal debt is roughly zero. Higher debt distorts consumption savings decisions and crowds out investment. Krugman just decided that this is a separate issue. He was talking about optimal G not optimal debt. Now in his model as written, it doesn’t matter when the government taxes because the model has Ricardian equivalence. Krugman doesn’t believe in Ricardian equivalence. I’m pretty sure that the policy which he really thinks is the one true optimal policy is a balanced budget expansion of G whcih will stimulate the economy and won’t build up increased federal debt. Obviously this is politically impossible and so Krugman doesn’t mention taxes in his little model.

Now to get his result he doesn’t strictly need that the increased G is financed at the time it is spent. With Ricardian non-equivalence, he could even get a larger effect of G by running up a deficit. However, as soon as the interest rate gets to be positive, he wants the debt to be as low as possible. In my “model” as unwritten, this would require the extra G of fiscal stimulus to be financed with taxes collected during the period of trapped liquidity. That’s not going to happen either.

Another model says that there are political limits on the budget (imposed by congress) and especially on taxes, so there is a minimum feasible deficit. This would mean that, once we are out of the crisis, Krugman would set the deficit to this minimum value (which might be a surplus). this means that all debt built up while the economy is in the liquidity trap will distort the mix between consumption and investment for a long long time, that is, until Krugman would have gotten the debt to the level he likes, which, I would guess, is zero.

The argument for accepting unemployment over 4.8% makes sense. In the “model” and in reality, the federal debt matters. Obama is not the fiscal authority. He won’t be able to pay back the debt built up during the crisis as fast as he would like. Therefore he doesn’t want to build up too much.

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How to Enron a CDS

Robert Waldmann

is back to his CDS obsession.

Imagine I’m a banker and I have this problem that they tell me I have to mark assets to market. I don’t like that because it makes my stated profits vary and my bonus depends on accounting profits and I don’t like the risk. How can I get around this ?

Well I can set up a special purpose entity and have it write me a CDS on some instrument I hold (they certainly have done this).

Now this doesn’t protect me from the risk that my instrument will default, because my special purpose entity won’t be able to pay up in case of default. However, it does remove my irritating mark to market problem.

How ? Now I have more assets to mark to market – the original instrument and the CDS that my SPE wrote me. Well fortunately AA rated AIG has also written CDSs on the same instrument and people are buying and selling AIG-CDSs on the instrument.

So I book my SPE-CDS as equal in value to the AIG-CDS. Huh ? That’s crazy. They are totally different instruments with totally different counterparty risk. In my example, the SPE has almost no assets, so its CDS is really worthless. However, the most similar asset which is bought and sold on a market is the AIG-CDS so the mark to market standards tell me to mark the value of my worthless CDS to the value of the AIG-CDS.

I am Enroning. Enron’s main scam was to set up special purpose entities and to book Enron’s claims on the SPEs as assets even though the SPEs were never ever going to pay up.

Now the scam as I’ve described it wouldn’t work — certainly not after the Enron bankruptcy. The transaction with my SPE is anything but arms length. I can’t pretend the price I chose as both parties in the CDS is a market price.

However, I think a similar scam can work if I have a friend at another bank who owns the same instruments. We each set up an SPE to write CDSs for each other. This transaction is still not arms length (I mean this is a scam) but it looks OK.

I think a lot of this was done, that is, a lot of CDSs were totally fake CDSs which everyone knew wouldn’t pay as promised if the insured instruments defaulted. I strongly suspect that a lot of CDSs were really MRSs, that is, a swap of mark to market risk, where one agent buys insurance against changes in the perceived probability of default on an instrument which hasn’t defaulted yet, but not against actual default.

It seems to me that such CDSs are not socially useful. They are useful as an accounting trick so that bankers, traders and hedge fund managers can hide their losses from investing in instruments whose value has declined by fake profits from instruments whose value is falsely marked to the value of a quite different instrument.

Does anyone doubt that people were doing this ? The question is whether a CDS was ever booked as equal to value to another CDS written by a different entity with different counterparty risk. Does anyone doubt that the answer is yes ?

Welcome to the modern world of finance. Aloha.

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