Category Archives: economists

What macro do we teach at the Principles level?

Every time I take a look at the principles level texts, it turns out to be a thoroughly entertaining experience! I usually look at how the authors have dealt with business cycles and more often than not the treatment turns out to be biased. For example take a look at this passage (pp. 273) from Hall and Libermann’s principles text. It looks at changes in labor demand as a cause of business cycles:

A Change in Productivity? One possibility is that the labor demand curve shifts leftward because workers have become less productive and therefore less valuable to firms. This might happen if there were a sudden decrease in the capital stock, so that each worker had less equipment to work with. Or it might happen if workers suddenly forgot how to do things— how to operate a computer or use a screwdriver or fix an oil rig. Short of a major war that destroys plant and equipment, or an epidemic of amnesia, it is highly unlikely that workers would become less productive so suddenly. Thus, a sudden change in productivity is an unlikely explanation for recessions. What about booms? Could they be explained by a sudden increase in productivity, causing the labor demand curve to shift rightward? Again, not likely. Even though it is true that the capital stock grows over time and workers continually gain new skills— and that both of these movements shift the labor demand curve to the right— such shifts take place at a glacial pace. Compared to the amount of machinery already in place, and to the knowledge and skills that the labor force already has, annual increments in physical capital or knowledge are simply too small to have much of an impact on labor demand.

So in making fun of the RBC school or the classical model, they totally forget to mention oil price shocks, creative destruction because of technological changes, weather shocks in developing countries, etc. According to the discussion that follows, business cycles are caused by sudden autonomous miscalculations of demand on the part of producers coupled with herd behavior or changes in spending coupled with malfunctioning credit markets or people keeping unspent money under the mattress!

Dismissing changes in labor supply as a reason for business fluctuations, they say the following:

One way the classical model might explain a recession is through a shift in the labor supply curve. Figure 3 shows how this would work. If the labor supply curve shifted to the left, the equilibrium would move up and to the left along the labor demand curve, from point E to point G. The level of employment would fall, and output would fall with it. This explanation of recessions has almost no support among economists. First, ­remember that the labor supply schedule tells us, at each real wage rate, the number of people who would like to work. This number reflects millions of families’ preferences about working in the market rather than pursuing other activities, such as ­taking care of children, going to school, or enjoying leisure time.  A leftward shift in labor sup-ply would mean that fewer people want to work at any given wage— that preferences have changed toward these other, non work activities. But in reality, preferences tend to change very slowly, and certainly not rapidly enough to explain recessions.

Now here the treatment is somewhat reasonable. However, there is no mention of preferences for work and leisure over time and how they could affect the labor supply curve or the fact that every time there is a recession, graduate enrollment goes up or government policies like welfare programs could affect unemployment duration (The Redistribution Recession story!).

Now I am sure Robert E Hall knows better than that.  For example look at this paper where he talks about preference shifts as causing changes in employment.  So instead of taking sides with one model why not present alternative explanations of an economic phenomenon?  Yes, the economy could be hit by real shocks or aggregate demand shocks or a combination of both or one turning into another. It is important to emphasize this to foster critical thinking and developing a balanced perspective.  When it comes to lack of a balanced perspective, most macro-principles texts are to be blamed and not just the one mentioned above. Thankfully, though, the textbook I use fares better and I kind of feel proud for not bombarding students with only one version of the story.

PS: Came across one more Principles of Macroeconomics that has a balanced treatment: Macroeconomics: Theory through Applications by Russell Cooper and A Andrew John published by Flatworld Knowledge.


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Krugman and Layard’s Economic Nonsense

What would Keynes say about the way his ideas are being used and abused to figure out what should policy makers do in the wake of recent financial crisis? I would like to believe he would not repeat his general theory. But leaving the speculation on this question for some other time, I would like to focus on Krugman and Layard’s manifesto for economic sense in today’s Financial Times. Interestingly, while arguing for differences in the European and US financial crisis, Krugman and Layard seem to have a single policy response as a panacea. This according to me actually seems to be a first step towards economic nonsense.

My reasoning is as follows: Among many other things related to how the ECB should function and whether Greece should stay or go, the European crisis is indeed a crisis of excessive public borrowing in countries like Greece, Ireland, Portugal, Italy and Spain. Contrary to this, K and L suggest that excessive public borrowing is a problem only in the case of Greece. To refresh on the EU situation, both of them might do good by reading or watching the work by Fernando Martin and Chris Waller of the St. Louis Fed. Fortunately, K and L get at least part of the US crisis right.  They say it was caused by “excessive private borrowing” but leave out the counterpart that this appetite was whetted by the financial system’s need for collateral to settle debts between themselves. While K and L somewhat agree with these differences, their blanket prescription for government spending in both the cases makes little sense. Looking at the level of public debt that the above mentioned countries have,  austerity does seem like the only way to go! On the other hand, considering the ‘paucity of good collateral argument’, at least in the long run US government  should borrow and spend more.

Now as K and L suggest, is there no evidence for deleterious effects of government deficits and the resulting borrowing on interest rates? The  rising yield curves on government debt for countries in EU,  (See this interesting  chart on Andolfatto’s blog), seem to suggest otherwise. It is probably only US that can still borrow at a lower interest rate without risking an immediate rise in the future interest rate. This is primarily because the US dollar still remains a strong international currency and the ability of the US government to honor its debt is not yet in doubt.  So as much one could argue for government spending in the US, especially on retraining programs or on Universities where the unemployed tend to flock, not all countries have the capacity to roll over their debt indefinitely and sustain such expenditure.

So what should be the manifesto for economic sense? Thinking carefully about the nature of the two crises and suggesting policy prescriptions based on such analysis or lumping both these crises together and somehow arguing that government spending is a panacea in both the cases? I pick the former while practical men seem to gobbling down the later keeping with the Keynesian adage of falling for a defunct economist!

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Filed under current economic issues, economists, European crisis, Macroeconomics and the crisis, Monetary Policy

Modeling the economist modeling the economy!

Saint-Paul Gilles of Toulouse School in Paris is one of those economists whom, you cannot afford not to read. If he writes it, you read it period. He has come up with a very interesting paper on the political economy of macroeconomic thinking- again a must read! you can find it here.

A few months back, I came across an interesting presentation by him titled “Endogenous Indoctrination“. He uses interesting techniques to see how indoctrination can evolve in a society and influence voter attitudes where teachers have a certain attitude towards the market system.


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Notes on Workshop on Financial Crisis, Montreal PQ

I was quite excited about this workshop. It had all the right speakers and almost everyone was eager to listen to what they have to say about the crisis. The workshop was didvided into two parts. In the first part, Timothy Lane from Bank of Canada, Robert Hall from Stanford and the Hoover institution and Narayana Kocherlakota from the Fed Minneapolis presented their thoughts on the crisis.

Timothy Lane’s talk was a good survey of lessons learnt so far from the crisis with a bit of central banker’s perspective. Robert Hall’s speech promised a lot. It was kind of a precursor to what he was suppose to talk the next at the SED plenary session (the plenary talk did not turn out be that interesting though!). One of the important points that he made based on the data was that the zero lower bound on the interest rate may not mean much if the rates faced by consumers are positive and sticky. The second arguement was that because consumption expenditure has been pretty resilient and productivity infact surged during the crisis the real business cycle explainations of the crisis are completely useless.

Narayana’s speech turned out to be the attraction of the evening.  Based on the idea that finanical investments by banks pose a negative externality and hence need to be internalized by taxing risk taking, in his speech he carefully laid out the arguement and some thoughts on how to approach its implentation.  When Kocherlakota was appointed as the Fed Chief, lot of people had doubts about his effectiveness as a policy maker. But he has time and again proved that clear and disciplined thinking can save the day anywhere. I am sure in the coming days this first rate theoretician will have many interesting things to say and I will be all ears!

The second half of the workshop was a round-table discussion by two Nobel prize winners- Bob Lucas and Ed Prescott and John Murray from Bank of Canada. It contained much of off hand talk by Bob Lucas and a no nonsense presentation by Ed Prescott. In spite of the argument by Bob Hall above,  Prescott continued with his RBC story of the crisis. He argued that Hall is wrong because data can be revised any time and mostly contrary to what Hall is saying. Hall argued that Prescott is wrong because his RBC story requires completely unrealistic estimates of Frisch elasticity. The most notable feature of the evening, however, was that in spite of the clash of titans, all the questions after the presentations and the round table were for Kocherlakota and his idea of risk tax. He kind of completely stole the show.

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S. Rao Aiyagari

This guy did some exciting work in incomplete markets among host of other issues. Unfortunately, he died very early. This is a write up by Neil Wallace on him which appeared in the Federal Reserve Bank of Minneapolis Review. It also lists most of the work done by Rao. You can also find his work here.

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Puzzles or Anomalies!

Economics is sometimes weird and economists weirder. Here is how the story goes. The world is too complicated to analyze completely. So what do we do? We could write and write and fill up volumes about nothing and everything and still obviously be far away from understanding anything. But Smith was smart and Marshall smarter. They modeled! Culled away unnecessary details and built a fabulous, frictionless and benchmark world where everything happened instantaneously. The curious breed of smart economists (read macro-economists!) decided to go further and knock themselves out by fine tuning this idealized world to the maximum extent possible. What did you say? You might break your finger on Aug. 24, 2020. No problem. Assume there is a insurance policy you can buy now to cover this exigency! This is how we got complete markets.

What will prices be in with these complete markets? Simulate and there you go- you have prices of goods, assets and what not. You name it and we tell you how much it should cost! Wait a minute, what did you say? The price seems to low than what you would have set given a free reign? Thats not good. Then my theory is useless! Oh my God! I just got a Nobel!.

What happened next was the economist wrote another paper telling how his earlier theory under predicts the actual returns in the economy and therefore we have a puzzle to deal with.

Now being an amateur economist (remember, I am supposed to be more dangerous than an economist!) I cannot come to terms with this idea of calling something a puzzle when all it is a self full filing anomaly. It is obvious that when you abstract from so many details which by some criteria deem unnecessary, the implications are ought to be at odds with reality. So the original theory itself came with the anomalous implication. What was new and unexpected about it to call it a puzzle?

No one has time for this semantics, though. As I write this post there is probably one more paper being written about a claim to a solution to this puzzle. And mind well, there are too many proposed solutions around already. Therefore, we need some more papers to suggest some criteria to choose among them. Sift and refine them, till only a generally acceptable one remains.

Sometimes it gets tough to get going with this seemingly nonsensical way of doing things. But then one realizes thats what progress is about. Dig and fine tune till you get to the truth. The ever elusive but constantly beckoning truth.

I guess it is far more easier to engage in this kind of intellectual exercise if we do it for the sake of fun of doing it. Its akin to saying you like solving and designing new puzzles. Anomalies masquerading as puzzles! Or is it the other way round?

hmm……let me see……here is how the story goes…….

you know I can go on like this right! I told you I am an amateur economist ;).

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