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Very Rude Comments

Simon Wren-Lewis gets me going again

He wrote

Rational expectations do not prevent us understanding sustained periods of deficient demand when an inflation targeting central bank hits a lower bound. Indeed they help, because with rational expectations inflation targeting prevents inflation expectations delivering the real interest rate we need, as I have argued here.


The traditional Phillips curve has always seemed to me to be an advertisement for the dangers of not doing microfoundations. It seems plausible enough, which is why it was used routinely before the rational expectations revolution. But it contains the serious flaw noted above, which almost destroyed Keynesian economics.

After the jump, two very rude comments (in anti chronological order)

update: welcome Krugman readers. Oddly I kept secret the really rude comment which attempts to support the thin gruel claim as made by Krugman (I e-mailed it to myself). I think I will try to keep it secret (but I mean how the hell did Krugman know I had written a thin gruel comment ? ) Anyway I put a semi almost not totally utterly rude version as a comment on his post and below so now there are 3 comments in anti chronological order.

the very rude comments I posted are nothing like the rude comment I decided to e-mail myself instead. In particular, they don’t contain much of the thin gruel claim. I think I will summarize the ones I didn’t post.

Wren-Lewis discussed changes in Central bank independence and explicit or implicit inflation targets.

When claiming one has evidence, one really can’t use the word “implicit.” Explicit inflation targets are observable variables. The claim that, without an explicit target, the Fed targeted inflation certainly isn’t an explanatory variable (and is hard to reconcile with FOMC minutes) . I’d guess the conclusion that there was an implicit target is based on the fact that inflation stayed at roughly the same level. If so, the evidence is that in cases where inflation stayed at roughly the same level, inflation stayed at roughly the same level.

There has been no change in the legal independence of the Fed. Yet US inflation was high in the 70s and low in the naughties. Again there isn’t a pattern relating observable variables with outcomes.

I didn’t add that 1973 -1968 = only 5 years. In many countries, workers didn’t accept that they had to live with capitalists. Unions were more powerful and vastly more militant. One might ask if one can explain differences in inflation rates by looking at difference in labor movements. For example, one might as Colin Crouch.

End update:

You write (suspected typo elided) “inflation targeting … delivering the real interest rate we need.” I note that the ECB has consistently targetted inflation (at least you are willing to give inflation targetting credit for events in 2005 and 2006. You must conclude that the Eurozone has the real interest rate we need.

But the Eurozone suffered a severe recession, currently has extremely high unemployment and appears to be headed for a second dip.

I think you meant to qualify the claim with “with the right inflation target, assuming (for some reason) that the target is credible …”


I too have semi defended the rational expectations assumption recently. However, the basic advantage I see is that the assumption of rational expectations makes it more difficult (not impossible) for people to tell stories about how their preferred policies are good, because (it is assumed rather than argued) they will influence expectations in a desirable way.

Briefly, I think the point is to exorcise the confidence fairy. Less briefly, my reasoning was that, if one is not required to assume rational expectations, one can argue that cutting spending will cause increased growth by increasing business confidence. A model in which businessmen with rational expectations increase investment and production because of a spending cut is not easy to write. My guess is that it would be a model with sunspot equilibria, so anything can change investment. If so the case for expansionary austerity would be identical to the case that what we need is to burn incense to the flying spaghetti monster (which claim is consistent with the rational expectations assumption on models where sunspots can matter).

The key question, I think, is not rational vs irrational. It isn’t even rational vs adaptive. It is whether we should treat expectations as a policy variable imagining that policy makers can control them as they control, say, the federal funds rate.

Then I thought “same for the people who think that expected inflation is just like the federal funds rate” and here we are. I might add, I also thought “this time I won’t be very rude in comment” really honestly. But, as I see it, you leave me no choice.

Look why not just talk about a monetary authority which targets real yearly GDP. To a million pounds per capital You are simply assuming that a central bank can get the inflation expectations it wants. That rational people will believe its dynamically inconsistent promises.

Oddly the last time I remember defending rational expectations was when I tried to explain (to Matthew Yglesias) why Paul Krugman was skeptical about the effectiveness of monetary policy right now.

I note again that you have not identified one advance new Keynesians have made beyond Keynes. The alleged examples include speculation about UK consumption some of which, you note, is not incorporated into new Keynesian models yet and none of which has yielded an improved prediction and, of course, the old Phillips curve. The only connection between the old Phillips curve and Keynes is that he warned against believing in it as clearly as anyone could writing before Phillips.

You contest Krugman’s claim that those who seek microfoundations have had no successes since the critique of the old Phillips curve yet you go back to that again and again. I see no trace of a justification for your disagreement with Krugman in this post or in any other post of yours which I have read.

Economists:Entrepreneurs::Blind Men:Interior Decorators

As part of my continuing series of Analogies that Should Be on the SAT, this is what Famous Entrepreneurs do (h/t Brad DeLong):

In the IBM PC era, Steve drove innovation forward with the Macintosh. This, like the Apple II, was squarely aimed at expanding the use of PCs to everyone, the “computer for the rest of us.” Everyone now knows that this was innovating too fast, and that cheaper, duller IBM machines running Microsoft’s dull clone of an earlier operating system would become the standard. But do you know how Steve changed when he realized that “the rest of us” were not going to buy the Mac? He learned that the most important early customers for Macs were corporate marketing departments (those graphics!) and worked hard to create, as he told me not long after, “the best computer company for those corporate marketers we can.”

This is what Nobel Prize-winning economists do (h/t Noah):

As Thomas J. Sargent, one of the leading proponents of the Rational Expectations Hypothesis recounted, “after about five years of doing [standard statistical tests] on rational expectations models, I recall Bob Lucas and Ed Prescott both telling me that those tests were rejecting too many good models.

“Real entrepreneurs don’t wallow in vision, they sell product.” “Real” economists, otoh…

Today in "Economists Are NOT Totally Clueless" (Part 3 of 4)

Pete Davis:

Treasury Secretary Hank Paulson initially sold Congress in the fall of 2008 on emergency intervention to purchase “toxic assets,” but quickly reversed course in favor of direct capital injections. Those favored financial institutions revived more quickly than most thought possible and most of those injections have already been paid back. However, most of the toxic assets remain on bank balance sheets, impeding new lending. [emphases mine]

At the end of the last post, I was ready to discuss “deadweight loss.” But a brief detour seems in order.

We used to talk a lot at this blog about DSGE models. Economists talk a lot about Equilibrium, even if they don’t fully understand it. At its core, saying “equilibrium” is saying “this is the best of all possible worlds.”  You can’t improve on equilibrium unless you choose a non-Pareto-optimal solution (i.e., a solution in which at least one person is affected negatively).

Equilibrium doesn’t mean you have achieved ideal social welfare. (Anyone who has looked at Game Theory for more than a minute can tell you that.)  But it does mean that things are “hitting on all cylinders.”  Or, more accurately, if the economy is not at equilibrium, the odds are better that people making choices will make mistakes.

Which is why I pointed to Brenda Rosser and especially this

“The way out of this thing is a shift in the way we treat the LDC debt,” Coldwell argued. “The banks would have to take a big hit on their balance sheets, but then it’s over. If you give them a definitive hit, then they could say it’s behind us. If you get down to a crisis stage, the banks would accept that. They would have no choice.” — William Greider. ‘The Secrets of the Temple – How the Federal Reserve Runs the Country’ Touchstone 1989. Page 549

If the banks take that hit, we’re back at equilibrium.  If they don’t, they continue to make suboptimal choices.  Which brings us back to the graphic.

There were several good suggestions for refinement in the comments, none of which can I do at the moment, since I’m working solely from FRED data. (General response: those acquisitions, especially WaMu, were made on terms that were agreeable to all acquiring parties. Which doesn’t mean those acquisitions may not be affecting the flow, but it’s likely more a question of acceleration than velocity, especially given the relative sizes of the institutions.)

But the FRED data is damning enough.  The risk management procedures at larger institutions were significantly worse than they were at smaller ones.  And the bigger they are, the worse they are becoming:

With several waves of doubt still to come, we are (choose one) (a) far from equilibrium or (b) still making suboptimal choices.

So let’s do a finger exercise.

Mortgages Outstanding approx. $11 trillion (Q4 2008)

Amount at risk (SWAG)25%

Expected Losses $2.75T

Fed Holdings (TARP, TALF, CPLF, etc.) approx. $2.2 T

Remaining Balance Sheet Exposuren approx. $550B

25% at risk seems about right.  Slightly over 10% of that $11T was Home Equity Loans, and the outstanding household debt at that time was about 123% of national income while equity was around 40%.

But note that this assumes that all of the special facilities remain in place. For instance, per Hamilton’s graphic, the Fed now owns about $1T worth of MBSes. CR notes that this program “is scheduled to be complete by the end of Q1.”

Of course, there are some cures that would be worse than the disease.  Via alea’s Twitter feed, I see that either the headline writer or the speaker made a slip yesterday:

“There ought to be government-backed ABS,” said Fed economist Wayne Passmore in a presentation to the American Economic Association.

Note that the quote is not (just) MBS but ABS—asset-backed securities, including credit-card receivables, car loans, basically any form of consumer (or other) debt that can be securitized.  The result of this would be that your tax dollars would pay a bank for your default on a credit card that charged you 30% interest, despite the risk-free rate being something near 0%—and almost always in the 5-8% range.

The reason we like equilibrium is that people who make mistakes do so because they are “being irrational.” When we’re not at equilibrium, we realize that they make irrational decisions all the time.  In what I hope will be the last of this series, we’ll look at irrational and rational decisions—and why irrationality may be the best survival strategy.

Today in "Economists Are NOT Totally Clueless" (Part 3 of 3 or 4)

This is taking longer than it should. For now, here is a “teaser” graphic, which I suspect is worth much more than 1,000 words:

Meanwhile, other (mostly related) thing you may want to read:

  1. Brenda Rosser find that everything new is old again.
  2. Steve Randy Waldman tells the truth about banks, and Shames the Devil, not to mention Tim Geithner
  3. Menzie Chinn discusses types of unemployment, and, implicitly, suggests that those who are arguing that structural unemployment (and, therefore, NAIRU) has risen are incorrect.
  4. James Hamilton notes that TARP was not the only program of support for financial institutions, nor will it likely be the last.
  5. Linda Beale finds Amartya Sen discussing “Rational Choice.”
  6. Rick Bookstaber raises a point Brad DeLong made a while back: inflation can be a very good solution to a true macro disaster.
  7. Mark Thoma finds David Cay Johnston’s examination of marginal rate data and economic growth.

Are TBTF Banks Out of Danger? The Market Doesn’t Think So

Down here it’s just winners and losers
And don’t get caught on the wrong side of that line

This will be a long post. Even with all the pictures above the fold.

It started with a finger exercise during my daughter’s swim team practice:

Just in case you thought I was picking on The Big C in my previous post, let us look at the other major financial institutions (Too Big to Fail, or TBTF, Banks) over the same time period.

The Remaining Investment Banks:

While Goldman Sachs—as with most of the other so-called Winners—shows a significant upturn and major gains since the beginning of 2009, Morgan Stanley’s appreciation has been rather less apparent. However, both have returned only to approximately the price they held during the interregnum (after Bear Stearns fell but while Lehman Brothers ignored the warning and decided not to right the ship).

The Mortgage Lending Leaders:

Both firms show an increase in stock performance beginning in Q1 of 2009. Wells Fargo had a precipitous dive after LEH filed bankruptcy, but recovered in a similar amount of time. JPMorganChase, having acquired Bear for either a song or too much money, remains below the level it reached during the interregnum, but solidly in the middle of its range since 2006.

The Consumers-as-Profit-Center (“Retail”) Banks:

As is apparent, Capital One’s stock decline was not precipitated by the proximate solvency crisis itself, but rather by the decline in earnings and profits, and deflation in wages, that was in full swing by early 2006. While Bank of America does not have that preamble, it sees a similar decline in its stock price from the middle of 2007. By the time the recession is officially declared, the trend has started. And while Bear’s fire sale to JPM causes a decline in bank stocks, it is not until LEH that BAC mirrors its competitors above. More like MS than GS, BAC’s recovery to less than one-half of its pre-recession trading price suggests that the market is less confident than management that the firm’s major issues are behind it.

But one thing abides. The market isn’t happy.

Even as we might divide this squad into Winners (GS, JPM, WFC), Losers (C, MS), and Also-Rans (COF, BAC), six of those seven (exception: JPM) appear to be viewed by the market as no stronger than they were during the interregnum, the time when everyone was waiting to see if the other shoe would drop.

There are certainly other reasons the stock price might be down: insider selling at the firms is at record or near-record levels, and sooner or later people will figure out that when insiders are selling at 82:1 levels is not the best time to buy. Their loans are down (post on that coming soon) while, as Linda notes at ataxingmatter:

A recent study suggests that big banks in the TBTF category now enjoy a significant cost-of-funds spread compared to other banks. That is, they can borrow money more cheaply, leading to greater ability to make profits, than can other banks, because of the implicit guarantee that the federal government will step in and save them because they are TBTF and pose a systemic risk. That advantage may amount to as much as 48% of the TBTF banks’ profits this year (or as ‘little’ as 9%, on very conservative assumptions). The government, by the way, gets nothing for this implicit guarantee–unlike a commercial guarantor, it is not being paid a regular premium for the service.

So maybe investors believe that this advantage will go away. (Or, as noted above, maybe investors have figured out that the Big Banks aren’t taking advantage of this opporunity, expecting that it will never go away.)

The one certainty is that, with all of their advantages (the refusal of the Administration to support cramdowns for non-investment properties, leading to perverted accounting that makes banks solvent and mortgageholders underwater at the same time on the same property; the continuing payment of interest on Reserves in a deflationary environment, which has created a perverse incentive for the TBTF Banks not to lend; charging their smaller competitors for the TBTF Banks’s failures by raising their FDIC contribution and collecting three years of it upfront after not having saved for a rainy day; having Administration economic policy run by Larry Summers, whose last foray into the financial markets was too embarassing even for him to explain (h/t Felix); Ben Bernanke having decided that doing only half his job should be enough (h/t Brad DeLong); and the general delusion that the banks are necessary to and helping with a recovery. And that’s off the top of my head.

As The Epicurean Dealmaker observed last week vin a post eeryone should read:

Chancellor [of the Exchequer Alistair] Darling could not have been clearer:

“I’m giving them a choice. They can use their profits to build up their capital base, but if they insist on paying substantial rewards, I’m determined to claw money back for the taxpayer,” he said.

[H]e plans to do this by making banks choose between their employees and their shareholders…

Economists have made this point repeatedly: the first priority of people who run a business should be their responsibility to their shareholders. (See Steve Randy Waldman’s post yesterday for a clear explanation. And then see the post he pulled from comments after that, which saves me the trouble of hoisting from another person’s comments again for the real ramifications of TARP and the bailout. Why do Megan McArdle and the Administration hate the troops?)

Paying large bonuses while the banks themselves remain near insolvency is bad for the shareholders. Goldman Effing Sachs realizes that, even if they didn’t quite go far enough.

Why do I believe the state of the TBTF Banks ranges from near insolvency (C, MS) to on the edge of insolvency? The market tells me so.

Inflation Detour: Trimmed Mean PCE

Today’s release by the Federal Reserve Bank of Dallas of October’s Trimmed Mean Personal Consumption Expenditure gives us a chance to check this “alternative measure of core inflation.”

The clearest thing is that it does what the FRB Dallas intends: generally reduces the measure of inflation:

For the graphic above, any value above the line shows where the 12-month Average of the Trimmed Mean PCE is greater that the Annualised CPI for that same period. With few exceptions, those points are places where the actual CPI is negative for the period. (Note also that all of periods where CPI is over 5.0-5.5% are below the line. While the 12-month average of Trimmed Mean PCE has a maximum of 8.7%, while CPI reaches slightly over 14.75% in the same time period.)

So the natural next step is to compare it to a measure of Consumer Sentiment. Let’s do that below the fold

Comparing Trimmed Mean PCE to the University of Michigan Index previously referenced:

Again, the preponderance of data points are to the right of the line, indicating that the Michigan Consumer Inflation Expectations is higher than the monthly Trimmed Mean PCE. But there is much more balance: the largest cluster of Expectations Dominance is between 2 and 4%; that is, periods of normal inflation.

The two measures correlate rather well with each other (86.13%) while a simple fitted regression that excludes a constant term has an adjusted R-Squared of 94.1% and yields MICH = 1.0416*Trimmed Mean PCE.

Trimmed Mean PCE may well understate inflation, but it appears to compare fairly well with what people think of when they think about inflation.

Inflation and Expectations

Ken Houghton follows up on his previous post.

One of the few honest statements that came out of the Reagan Administration was in late 1982, when the Volcker policies were working but the market was still spooked. “People expect that inflation will be higher than it will be.”

The above compares the University of Michigan’s Consumer Sentiment (prediction of the inflation rate one year forward) with the actual inflation that occurs over that period.

Several things are apparent.

  1. The official inflation target was not really managed well from 2004-2006. (Alternate explanations welcome; I can think of a few.)
  2. Consumers assumed the Fed targets were in effect during that period.
  3. Consumers have consistently overestimated inflation from 2007 onward—and there is no sign of that changing.
  4. There has been deflation since the beginning of 2009.
  5. People still believe the Fed target can be hit.

Combining those last two leads to another clear conclusion that I hope has an alternate explanation: Consumers continue to try to believe the Fed target, even in the face of policy failure.

This may explain the “bizarre complacency“; people believe the economy is in a much different place than it is.

But for how long can they ignore the evidence?

To Be Continued…

How Do We Predict Inflation?

Ken Houghton notes that playing with data is dangerous.

Predicting the future tends to be easy. There are several ways to do it. First, you can predict that everything will grow as it did this year—or last year, or the mean of the past x years. Or you can predict that it will be great if a Republican is in office, but horrible if a Democrat is. (Call this The Kudlow Effect.)

Or, you can just predict that everything next year will be the same as it is this year.

This appears to be fairly close to what consumers do, judging by this scatterplot of annual inflation (i.e., inflation over the previous twelvemonth) against the University of Michigan’s median expectation from consumer surveys.

So the “Rational Agent” believes that nothing will change. Comments?

So Did Lucas Create HyperRational Expectations?


Lots of people appear to be forgetting this one or getting it wrong…the central model of The General Theory of Employment, Interest and Money is a rational expectations model.

The difference with the soi-disant “rational expectations” school is over the expectations-forming process with respect to the effect on price and output of monetary policy, not anything else. Hope that’s cleared up now. [emphasis, style change mine]

I think I see the problem now. Everyone obsesses over every aspect of fiscal and monetary policy. When do they work—and, more importantly, how do they develop skill sets and core competencies (“competitive advantages”)—in the Lucas model?

The Measured Version of My Screaming

John Quiggin finally makes explicit What Everyone Knows: that the clusterfuck that has been made of Macroeconomics is due largely to an attempt to leverage (insufficiently robust) Microeconomic Theory:

the search for a macroeconomic theory founded on (roughly) neoclassical micro, which has been the main direction of macro research for 40 years or so, was a wrong turning, forcing us to retrace our steps and look for another route.

Think Lucas and Prescott as Mirror-Moses, leading gullible Macroites further and further from the Promised Land, themselves evermore unable to ask for directions.* Couldn’t have said it better, or with so few expletives, myself. But then, that’s why he has a book contract.

Read the Whole Thing.

UPDATE:*Or, probably more accurately, think the years Christ spends between “I have thirst” and realizing that his long, happy peaceful life was The Last Temptation, as per the movie and novel of that name.