Strange Defeat: An Exchange

Since EPW decided not to publish any further correspondence between Jaydev and Mason & me, I am giving the link to Mason’s blogpost on the subject below:

http://slackwire.blogspot.com/2014/08/strange-defeat-exchange.html

Of course, I had a response to their response, which EPW decided not to publish! So for those who are interested here it is:

On Modern Macro: A Response to Jaydev and Mason
Parag Waknis

In what follows, I try to address the concerns raised by Jaydev and Mason in their extremely civilized and professional criticism, “A Response to Waknis” in November 2, 2013 issue of this journal!

Optimizing agents and the EU debt:
Financial markets not being able to price the EU debt correctly prior to the crisis does not contradict the rational optimizing framework really. It only reflects the ambiguity that comes with a monetary union that is not a fiscal union. Hence, even though the default probability might not have been same across members, absence of a severe shock, investors may have perceived it as so. Despite the significantly different fiscal situations of member countries, convergence of inflation across the EU members might have supported such valuation. But a shock as severe as the US financial crisis can force investors to reevaluate their portfolio positions in order to minimize risk and that is what seems to have happened. Given that asset prices are conditional variables and that pricing being a discovery process, this response of investors actually seems reasonable and not so off the mark from the optimizing benchmark.

Microfoundations:
I am not arguing for only one kind of microfundaions. A rational optimizing agent is a useful benchmark in macroeconomic modeling but may not be appropriate for answering all the questions macroeconomists ask. Several alternative avenues of modeling expectations have been explored in the literature and sometimes confrontations with data have helped explain the disagreement between reality and the theoretical benchmark (See Sargent (1999)). Macroeconomists face special problems in terms of evaluating a policy as they only have model economies at their disposal. Then search has to be for policies that are robust to several different model environments. Hansen and Sargent (2008) develop an agenda along these lines.

In short, there is substantial heterogeneity in macroeconomics and there are enough examples of how macroeconomists have pushed forward the research agenda to address basic methodological issues and limitations. Concentrating ones critique on certain frameworks that gain primacy and generalizing it to the whole field at best betrays ignorance or at worst belies an ideologically motivated critique!

Unemployment in the US and Europe:
The difference between European and US unemployment is not a new phenomenon. European unemployment on an average has been consistently higher than the US for past 30 years. Prior to 1970, EU countries had similar unemployment durations as the US but lower inflows to unemployment keeping their unemployment rate low. After 1970 this changes, though. The inflows to unemployment remain the same but the typical duration of unemployment is much longer in EU countries than in the US making EU unemployment rate higher. So how do we account for this reversal in the comparative unemployment regimes despite the persistency of institutions in both the continents? Ljunqvist and Sargent (2008) provide an answer. They show that the unemployment effects of higher unemployment insurance and employment protection depend on the amount of economic turbulence represented as skill depreciation at moments of involuntary separation.

At any given point of time in their economy, there are two types of job separations. One is voluntary- people who quit their current job to look for another and possibly a better one. These people are secure in their skills and do not experience a skill depreciation when they quit a job. In contrast to these workers are those who are laid off. These contribute to involuntary separations and imply skill obsolescence. Economic turbulence is defined as negative shocks to laid of workers’ earning potentials. Given this description of the economy, which pretty much sums up the economic environment that workers in the EU and the US faced after 1980, it is not hard to see how generous and long lasting unemployment benefits would provide a higher incentive to the unlucky workers for staying unemployed keeping the unemployment rate in the EU higher than the US up until recently.

The recent change in employment benefits in the US seems to have altered this situation bringing unemployment rate in the EU and the US closer. So the authors should not be surprised that in 2009 US and EU rates are identical. The US workers are staying unemployed longer like those in EU there by pushing up the unemployment rate even though the inflows to unemployment pool have not changed substantially. As I mention in my response, Mulligan (2012) confirms that increases in unemployment benefits has been one of the reason for increasing the unemployment duration. In a similar vein but highlighting a different mechanism, Hagedorn et.al (2013) show that the increased unemployment benefit eligibility during the great recession affected the rate of job creation contributing to the higher unemployment in recent periods.

The example of Denmark and Norway that the authors provide only highlights that there is substantial heterogeneity within Europe but most of the numbers seem to be on the higher side pulling the average well above that in US. Taking a survey of the literature on this issue, Blanchard, Bean and Mucnhu (2006) argue that most of the theories that have been put forward regarding the labor market institutions explain the persistently higher unemployment rate in EU quite well, with a caveat that differences in labor market institutions within the EU countries might explain the differences within the EU countries.

While ridiculing the suggestion that unemployment has increased in the US because of increased unemployment benefits during the Great Recession, the authors suggest that “One useful contribution that I might make is interviewing unemployed workers, and asking them how they are enjoying the vacations they have chosen. We expect he will find the answers most stimulating (Italics are mine)”. As an answer let me give this graph from an “undergraduate macroeconomics’’ text:

gradenrollment
Source: Cowen and Tabarrok (2013), Modern Principles: Macroeconomics, Worth Publishers, 2nd Edition, pp. 5.

So the unemployed seem to be vacationing in the several thousand universities across the US! To be fair to the academic bent of this article and journal, research shows a differential impact of unemployment on graduate school enrollment rates according to gender and GPA (see Johnson 2013 as an example). As far as ability is function of economic conditions, I do not think that life of an unemployed is an easy one.

Government Expenditure Multiplier:
I said in my response that if the expenditure multiplier is 1.5, then a dollar of government spending adds at best 50 cents to the GDP. I was hoping that the authors would be careful enough to read that as net addition to the GDP. So just to clarify, I do not regard this situation as crowding out. However, an estimate below 1 does mean crowding out. Also, many of these estimates are based on defense spending in the US and entail an increase in distortionary taxation. A government expenditure increase on some different category of spending or financed in a different way may have different impact. For example, infrastructure spending might have a positive impact on productivity of the private sector (Ramey 2011). This may not provide a sufficient rationale for increasing government spending in a developed country like the US that already has a huge stock of infrastructure but definitely does so for a developing country like India that falls short on that front.

However, by saying, “most empirical economists prefer estimates on the higher end”, the authors seem to suggest that most government spending either is financed in a non-distortionary way and/or it is spent on commodities that affect the private sector productivity. I am not quite sure if that is true. If government spending rises through changing unemployment benefits eligibility, would it have similar incentive effects as funding defense research projects?

About Aggregate Demand:
What role does aggregate demand play in causing business cycles? According to Old/New Keynesians the answer is possibly shortage in aggregate demand, most of which comes through reductions in autonomous investment. I don’t necessarily disagree with this, even though I do not agree with their reasoning behind such shortage* . The important question however, is whether government spending can plug this shortfall in spending and prop up the economy out of recession or would the effect of government spending depend on what might be the cause behind decline in spending? For example, if consumers have already built up a lot of debt and hence are holding spending back in economic downtimes, then would giving them additional money make them actually spend it? There is ample evidence from the analysis of the 2008 tax rebate to suggest that it does not. Most of the extra money was used by households to repay back some of the accumulated debt. So the immediate impact of a tax rebate was increased savings. According to Sahm, Shapiro and Slemrod (2010), the distribution of survey answers to questions about the use of tax rebates in 2001 and 2008 corresponds to an aggregate MPC after one year of about one-third.

Another aspect of recessions, especially after a severe crisis, is destruction of match capital or relationship capital as argued by Andolfatto (2010). Relationships like firm/worker, creditor/debtor, supplier/retailer, etc. are destroyed by the crisis and rebuilding them might take time. This would be especially true if these matches looked good ex ante but not ex post. How does government spending help in this case? May be instead a permanent tax cut might help!

The point is that we should know why aggregate spending is falling short, if at all, in order to see what government policy might work. If the national income was just an identity, then it might have worked to spend and plug the hole. However, there are actual people taking economic decisions and hence the effect of a policy on structure of incentives in the economy matters. Otherwise why not argue for infinite government spending?

___

*It is typical of the Keynesian school to assume nominal stickiness in wages or product prices. However, note that the failure of markets to clear as implied by price or wage stickiness is not enough to generate stickiness in the aggregate price level required to cause a shortage of aggregate demand. See Barro (1977) for an example of early theoretical work showing this.

References:

Andolfatto D, 2010, Deficient Demand: The Deflated Balloon Hypothesis. Link accessed on November 5, 2013.

Barro, Robert J., 1977. “Long-term contracting, sticky prices, and monetary policy,” Journal of Monetary Economics, Elsevier, vol. 3(3), pages 305-316, July.

Blanchard, Bean and Munchau, 2006, European Unemployment: The Evolution of Facts and Ideas, Economic Policy, Vol. 21, No. 45.

Mulligan, Casey, 2012, “The Redistribution Recession- How Labor Market Distortions Contracted the Economy” Oxford University Press, New York.

Ramey Valerie A., 2011b. “Identifying Government Spending Shocks: It’s all in the Timing,” The Quarterly Journal of Economics, Oxford University Press, vol. 126(1), pages 1-50.

Hagedorn M et.al, 2013, Unemployment Benefits and Unemployment in the GreatRecession: The Role of Macro Effects, NBER Working Paper 19499, October.

Ljungqvist L and T Sargent, 2008, Two Questions about European Unemployment, Econometrica, Vol. 76, No. 1, pp. 1-29.

Johnson M, 2013, The impact of business cycle fluctuations on graduate school
Enrollment, Economics of Education Review 34 (2013) 122–134

Sahm Claudia R., Matthew D. Shapiro and Joel Slemrod Household Response to the 2008 Tax Rebate: Survey Evidence and Aggregate Implications, , in Tax Policy and the Economy, Volume 24 (2010), The University of Chicago Press

Sargent T, 1999, The Conquest of American Inflation, Princeton University Press, Princeton and Oxford.
Hansen L P and T Sargent, 2008, Robustness, Princeton University Press, Princeton and Oxford.

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NBER Summer Institute

An interesting and informative summary by John Cochranne of NBER summer institutes on Economic Fluctuations and Growth and Asset Pricing.

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Picking on Piketty!

So like many other fellow bloggers, amateur economists, savant economists, and Nobel laureate Paul Krugman, I have my copy of Capital. This time the author is Thomas Piketty and not Mr. Marx though. I am yet to read the book- not sure if I will ever get to it amidst semester ending, grading and fulfilling research requirements. So I wanted to get a quick take on what macroeconomists have to say about the book. Not surprisingly, Steve Williamson had a post- but he was yet to read the book. So I guess we will have to wait for his critical comments or not as he is more into figuring out what Fed should be doing! Meanwhile this following comment by Tony on Steve’s post provides a good critical view:

Piketty’s book does not contain explicit references (to the best of my knowledge) to the two-decade-old body of work on macroeconomics and inequality beginning with Huggett and Aiyagari. Neither does the book’s online appendix, but if you follow the links provided in this appendix to other papers that Piketty and co-authors have written you will find references to some of this work. (That does not count as a citation in my book but it shows at least that Piketty is evidently aware of some of this work.) But for reasons that are unclear to me Piketty does not seem persuaded by papers like Castaneda, Diaz-Gimenez, and Rios-Rull (JPE, 2003) which match most of the facts about U.S. income and wealth inequality with parameters calibrated more-or-less reasonably. Instead in his book (which I have still not yet finished) and in a very recent paper (April 2014) with Zucman he seems to favor fairly mechanical models with multiplicative shocks to individual wealth accumulation. These models generate power laws for the upper tails with coefficients that evidently depend on the now-infamous “r-g” (i.e., the difference between the interest rate and the growth rate). But he does not make much of an attempt to calibrate them as do Benhabib et al (Econometrica et al, 2011). My overall impression so far is that Piketty does not really engage the existing literature on income and wealth inequality. Maybe this is because he focuses almost exclusively on the upper upper right tail of the wealth distribution (not just the top 1% but the top 0.1%). Krusell and Smith and Castaneda et al and others do a pretty good job of matching the top 1% but perhaps (and I am not sure about this) less well on the top 0.1%. But then in his book he makes bizarre statements like “the profession [has an] undue enthusiasm for simplistic mathematical models based on so-called representative agents”. He knows this is not true! (He was even a discussant for Quadrini and Rios-Rull’s forthcoming chapter on “Inequality in Macroeconomics” in the Handbook of Income Distribution.) Inexcusable.

There is also this article from 2012 on VOX that might interest you. And as the famous econblogger Noah Smith once tweeted: stop spelling Piketty as Picketty ;)

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Unconventional Monetary Policy in an Interconnected World!

I came across this news item from CNBC about Bernanke and Rajan face-off and that was enough to break the long blogging hiatus!  Rajan raises an important question that should be addressed given today’s closely connected economic systems. In the context of unconventional monetary policies, he asks “If the policy hurts the rest of the world more than it helps the United States, should this policy be pursued?”  This question is important because there has been a lot of debate about the domestic impact of Fed’s QE policies , but not much has been said about the effects of such policies on emerging market economies. In fact, Rajan puts it quite bluntly when he criticizes “the Fed for failing to mention turmoil in emerging economies in its January 2014 policy statement, sending “the probably unintended message that those markets were on their own,” a sentiment reinforced by public comments by regional Fed bank presidents.” (Source)

While some macroeconomists and even the new Fed Chairman continue to argue about the favorable effects of QE and the eventual low interest rate regime, there has been a convincing argument against it made by New Monetarists like Stephen Williamson here and more informally here.  The infromal argument in short goes somewhat like this: if money competes as means of payments with other assets playing similar role (shadow banking) and if QE is increasing their prices, then the only way money can retain value is if inflation goes down. So we have an imminent danger of Japaneese style stagnation as the lowering of interest rates and increase in value of money creates a liquidity trap.  This is quite apparent in the data and hence quite surprising that Fed continues to neglect it when it comes to policy making. Thus, given that the benefits of QE for the US itself are circumspect or unclear at best, Rajan’s criticism seems valid and timely. Of course, Bernanke did not take it well- he does not want any blemish on his legacy! Not sure what to think of his argument about QE being demand augmenting as suggested by required exchange rate intervention.

Notwithstanding this face-off between two first rate scholar central bankers, something definitely needs to be thought about policy making in an interconnected world economy-especially in case of the US who supplies the world’s most prominent reserve currency and the general shortage of safe assets as argued by Caballero. It looks like there was some talk about this in Kansas City Fed in 2012, the Jackson Hole symposium in 2013, and very recently at the IMF. Rajan’s proposal in this regard seems interesting and worth researching. He sees “merit in assigning the International Monetary Fund or a similar institution the responsibility of assessing the spillover effects of major central banks policies – much as the World Trade Organization does with trade rules – but acknowledged this isn’t politically viable.” 

Whether, such a solution is possible or not, the argument against activist monetary policy favoring low interest rates has never been stronger than now. As James Bullard suggests here, there is a strong evidence that low interest rates may have prolonged the recession that started in August 2007, when firms speculated in the international oil markets using the abundantly available cheap funds and literally engineered an oil price shock! Of course, real data available to Fed at that time did not reflect this and significantly understated the extent of actual recession. Talk about lags in policy making eh!

 

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ASSA 2014 Highlights

Despite the awful arctic cold wave, attending ASSA 2014 in Philadelphia was a delight as it is every year! The sheer amount of energy and enthusiasm that comes from such a large professional gathering is really unparalleled. Economists also seem to be getting better at entertaining themselves, if this year’s music and humor sessions are any indicator. But most off all, for me, the highlights were AEA/AFA luncheon with the recent Nobel Laureates Ms. Fama, Shiller and Hansen :) and continuing education series on Economic Growth.

Due to illness, Fama could not actually make it to the luncheon but he was ably represented by his long time coauthor Ken French. The conversations were well facilitated by Luigi Zingales of Chicago Booth. Some interesting highlights:

On bubbles: There is nothing called as bubbles- there is only volatility in asset prices.

Take on market efficiency: Bob Shiller thinks that efficiency of markets is only half truth but nonetheless a very significant one. Hansen responded by saying that the function of financial markets is aiding resource allocation in the economy. Hence, the more important question is about its role in promoting allocative efficiency. This, according to me, is one of the clearer statements of how economists should look at the process of financial intermediation.

While elaborating on the half truth comment, Shiller, who came across as an extremely soft spoken yet a very candid speaker, said that any profession should be wary of ‘group think’. This refers to the blind spots that professionals develop to obvious gaps in understanding a phenomenon as more and more people buy into the dominant thinking framework. That was a very interesting point.

Optimal Investment Strategy: If markets cannot be predicted, what should be the optimal investment strategy? According to Shiller, people should seek advice from paid professionals and there should be more of them available.

The second interesting session I attended was ” What Macroeconomists should know about finance?”. It was a panel discussion constituted by Markus Brunnermeier, Atif Mian, and Arvind Krishnamurthy. Some interesting points about macro-finance linkages that were made in this discussion were as follows:

1. Atif Mian: Debt matters for macro aggregates through:

  • Asset Price Channel: asset prices declined faster in states where foreclosure laws are laxed.
  • Aggregate Demand Channel: HH that suffer higher net wealth shocks cut back on spending. Higher level of leverage means that aggregate losses are going to be shared by levered households disproportionately. Decrease in demand leads to reduction in tradable and non tradable jobs.
  • Financial Rigidity Channel: absence of state contingent debt. Rigidity in financial contracts. Hence, important question is why are private contracts not optimal from macro perspective.
  • Endogenous risk = systemic risk

2.  Arvind Krishnamurthy:

  • Multiple asset prices- Do not respond in synchronous manner.
  • Careful thought to Intermediary asset pricing is needed.
  • Market segmentation: Importance looking at process of intermediation for macro.
  • Changes in risk premia are not included in standard macro.
  • Capital structure of financial firms is not irrelevant as macro assumes.

3. Markus Brunnermeier: Unfortunately I missed this presentation-I definitely blame it on cold weather ;)

The best part was the continuing education series on economic growth. Oded Galor and David Weil did an extremely good job of summarizing the existing research, commenting on intricacies of research designs and giving a clear picture of what we know about economic growth till now. Further, Galor’s Unified Growth Theory is a sure winner according to me. His paper on genetic diversity and comparative economic development was supremely exciting! You can access his research from his IDEAS page. You can access David’s research on health and economic growth here.

Update (January 11, 2014): Not sure why and how I missed this- Claudia Goldin’s Presidential address tops everything-you can watch it here.

Update (January 19, 2014): Interesting presentation on Railways and Famines in India. Check it out here.

 

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On Cows and Central Tenets of Capitalism!

Santosh Anagol has been doing interesting research on several phenomena concerning the Indian economy. In a recent paper, he and his coauthors estimate that returns to owning a cow in India are negative and hence the continued existence of cows violates the central tenets of capitalism.

Daron Acemoglu and James Robinson discuss these findings in their extremely interesting blog here. They argue that social embeddedness could help us understand why cows are still a part of a typical Indian farmer’s portfolio. I think that their arguments certainly makes sense, however, one might also look at new monetarist economics for an answer to this question. For example, Lagos and Rocheteau (2008) analyse an economy with money and capital as competing media of exchange and their model I think could explain this puzzle that Anagol et.al pose.

In their economy, agents over-accumulate capital in a non-monetary equilibrium because the capital asset performs the function of a productive asset as well as a liquid medium of exchange when needed. The introduction and use of money therefore allows the liquidity use to be separated from the productive use and corrects the inefficient over-accumulation of capital. Thus, fiat money plays a welfare enhancing role in this economy. However, that precisely does not seem to be happening in India and that is the puzzle that Anagol and his coauthors are referring to.

So why do Indian farmers seem to be preferring to invest in an asset that has negative returns, despite the availability of a liquid medium of exchange? Here, it is important understand what constitutes return on capital. Lagos and Rocheteau propose that return to capital in such an economy can be thought of being comprised of two parts: a liquidity return referring to capital’s role in exchange process and the intrinsic return associated with the productive use of cows. Anagol’s analysis seems to be capturing only the intrinsic return while cows continue to have a liquidity return (premium) in the minds of Indian farmers. Ideally, this perceived positive liquidity return for cows should not prevail if fiat money does provide the necessary insurance against uncertainty. The fact that it does implies that the insurance provided by access to fiat money is not enough.

Anagol and his coauthors do raise this point but dismiss it citing the proliferation of different forms of microfinance institutions in rural India increasing access to savings. However, research has shown that actual use of these institutions is quite uneven and tends to depend on factors that could be explained using the economics of networks. For example see Matt Jackson’s work here. I think the factors mentioned above still continue to influence the basic uncertainty that farmers face in a substantial way. I am not sure if microfinance would be able to provide enough insurance in case of a crop failure for example. Because provision of funds in such case may require access to a mechanism to transfer funds from non-affected areas to affected areas to meet the demand and microfinance in its current state most likely is not in a position to handle that.

I still think that social embeddedness plays an important role. On the one hand traditional socioeconomic relationships have broken down reducing the access to mechanisms that could serve as partial insurance mechanisms and on the other hand access to modern monetary economy is still hard to come by. Lack of roads, absent storage and refrigeration facilities, ineffective or absent land reforms, inadequate irrigation facilities keeping agricultural output sensitive to rainfall shocks, all imply that the benefits from participating in the market economy only add to the existing uncertainty that these farmers face. Till these issues are addressed Indian farmers will continue continue to hold cows despite their negative intrinsic return.

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Fiscal Stimulus: Old Keynesian vs. New Keynesian

This is fascinating stuff! John Cochranne urges us to call spade a spade and be done with it in this very interesting blog post: New vs Old Keynesian stimulus. Then you have Steve Williamson commenting on Cochranne here: John Cochranne and Keynesian Economics, while Nick Rowe adds his own views on these differences here: On understanding and spinning your own New Keynesian model.

You can find John’s extremely insightful paper here: New Keynesian Liquidity Trap.

Enjoy!

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