Archive for May 2010


Against models: The Good, the Bad, and the Ugly

I got to thinking about macro models while reading a recent Mark Thoma post on the debate between those who defend modern macro models, and those like Krugman and DeLong who wish to move away from highly abstract and unrealistic models (new Keynesian or new classical)  and toward something more realistic.  I’m not quite sure what that is, but I believe they think it would be something that incorporates insights from people like Keynes and Minsky, and something able to deal realistically with policy options at the zero rate bound.

I know this is going to sound arrogant coming from a pipsqueak at Bentley, but I think both sides are wasting their time.  I think we need to move away from macro models, or at least macro models of the type that are the primary subject of dispute.  I can think of at least three types of macro models:

1.  Models that attempt to explain in very simple terms how key macro variables get determined; IS/LM, AS/AD, money supply and demand, loanable funds and interest rates, etc.

2.  Models that try to show the relationship between changes in macro variables like the price level and output, and unobservable changes in the social welfare function (such as the menu cost of inflation, or involuntary unemployment.)

3.  Models that attempt to predict movements in the key macro variables, and make conditional predictions based on various settings of monetary and fiscal policy levers.

The first type of model is fine, as a pedagogical device.  The second are useful in principle, but in practice we mostly go with the gut.  We assume that demand policy probably doesn’t affect the long run rate of real growth, so we try to reduce the amplitude of the business cycle.  We also believe that inflation should be predictable.  Many economists believe that a stable price level minimizes the welfare cost of inflation, almost all believe the optimal inflation rate in the US is between about minus 2% and plus 4%.  We really don’t have any way of showing who’s right, although the answer might depend to some extent how well we deal with the third problem.

The debate is focused on the various structural models of the economy.  What happens if we cut the fed funds rate by 1/2%, or increase the budget deficit by $300 billion?  We expect answers from our models, and the more Keynesian models generally give slightly different answers than the so-called “freshwater” models.

What I find so odd about this debate is that modern macro theory is often assumed to generate some sort of highly technical structural model featuring rational expectations.  But that’s not at all what modern macro theory implies.  Modern macro theory implies that policymakers should get the optimal forecast of the policy goal variables, conditional on various policy settings.  And modern macro theory suggests that the best way to do that is to create and subsidize futures markets that trade contracts linked to variables being targeted by policymakers.  Indeed in the case of monetary policy, money should be convertible into those contracts.  And since the price of those contracts presumably has no zero bound, there is no case for fiscal stabilization policy.

You might object that if we don’t build these models, then the markets will lack the sort of information required to make intelligent forecasts.  I suppose that’s possible, but I have two problems with that argument.  First, there will always be people trying to model the economy, so I’m not worried about that.  I’m not even opposed to having the government fund a couple hundred model-builders at the Fed on the grounds that the information it would provide is a public good.  What I oppose is the Fed actually using the information from their economic research unit.  Let the markets use that information, if they think it’s useful.

Will the markets think it’s useful?  Ask yourself this question:  In the first 10 days of October 2008, when markets rapidly scaled back NGDP growth forecasts as they received extremely bearish reports regarding AD all over the world, and saw the Fed policy seemingly helpless to arrest the decline, which macro model were markets looking at?  Don’t these models usually put in lagged macro data of various sorts, the sort of data that’s reported monthly or quarterly?  What sort of data would have caused such bearish sentiment that stock prices fell 23% in 10 days?  I suppose you could put in market data measured in real time, but if you are going to do that, why not skip the middleman?  Just create a market in the variable you care about, don’t try to infer NGDP growth by putting other real-time market indicators into your model.

So here’s how I see things:

The Good:  Create a NGDP market and stop trying to outguess the markets.  If you don’t like NGDP, create separate price level and RGDP futures markets, and stabilize a weighted average of the two contracts along the desired growth trajectory.

The Bad:  Try to create a structural model of the economy, under the assumption that the public sees the world the way you do.  I.e., if you think X causes Y, don’t assume the public believes that X doesn’t cause Y.  In other words, use consistent expectations (unfortunately these are misleadingly called rational expectations–it has nothing to do with rationality.)  Input data and predict.

The Ugly:  Create a model that assumes you are smarter than the public.  Also assume that monetary policymakers are really dumb, and don’t know how to do policy at the zero bound even though your model says they can do monetary stimulus at the zero bound.  But fiscal policymakers are wise, and free of all political influence.  Once all these assumptions are built in, you are free to indulge your wildest left-wing fantasies.  All the laws of economics go out the window.  No more opportunity costs—build pyramids in the desert, or high speed rail between Tampa and Orlando.  Payroll tax cuts cost jobs, but higher minimum wages actually create jobs.  Protectionism is also great, especially when directed against oriental people people who live in high-saving cultures.

I suppose that in the debate between the bad and the ugly I should support my freshwater alma mater.  But I can’t even get up enough enthusiasm to enter the fray.  Once you start thinking in terms of NGDP futures targeting, everything else seems pretty pointless.

PS.  Don’t tell me markets are irrational.  The point is to stabilize NGDP expectations; according to modern macro theory (Woodford, etc.) unstable expectations of future NGDP causes unstable current NGDP.

Update 5/28/10:  Nick Rowe has a related post on this issue.  I agree with his commenters that there is an important distinction between unconventional forecasts (aka witchcraft) and making conditional forecasts based on alternative policy choices.  But even the latter are inferior to futures markets.  After I did this post I realized that I should not have implied that all policy issues revolve around NGDP—I was thinking of demand-side policies.  It would be considerably harder to set up prediction markets to evaluate supply-side policies, but nevertheless there is no reason in principle that it couldn’t be done.  Interested readers should look at Robin Hanson’s work on “futarchy.”

Now that the money supply is falling fast . . .

Where are those who warned us that rapid growth in money foretold hyperinflation?  Are they now predicting deflation?  From the Telegraph:

The stock of money fell from $14.2 trillion to $13.9 trillion in the three months to April, amounting to an annual rate of contraction of 9.6pc. The assets of insitutional money market funds fell at a 37pc rate, the sharpest drop ever.

“It’s frightening,” said Professor Tim Congdon from International Monetary Research. “The plunge in M3 has no precedent since the Great Depression. The dominant reason for this is that regulators across the world are pressing banks to raise capital asset ratios and to shrink their risk assets. This is why the US is not recovering properly,” he said.

.   .   .

Mr Summers acknowledged in a speech this week that the eurozone crisis had shone a spotlight on the dangers of spiralling public debt. He said deficit spending delays the day of reckoning and leaves the US at the mercy of foreign creditors. Ultimately, “failure begets failure” in fiscal policy as the logic of compound interest does its worst.

However, Mr Summers said it would be “pennywise and pound foolish” to skimp just as the kindling wood of recovery starts to catch fire. He said fiscal policy comes into its own at at time when the economy “faces a liquidity trap” and the Fed is constrained by zero interest rates.

Mr Congdon said the Obama policy risks repeating the strategic errors of Japan, which pushed debt to dangerously high levels with one fiscal boost after another during its Lost Decade, instead of resorting to full-blown “Friedmanite” monetary stimulus.

“Fiscal policy does not work. The US has just tried the biggest fiscal experiment in history and it has failed. What matters is the quantity of money and in extremis that can be increased easily by quantititave easing. If the Fed doesn’t act, a double-dip recession is a virtual certainty,” he said.

Mr Congdon said the dominant voices in US policy-making – Nobel laureates Paul Krugman and Joe Stiglitz, as well as Mr Summers and Fed chair Ben Bernanke – are all Keynesians of different stripes who “despise traditional monetary theory and have a religious aversion to any mention of the quantity of money”. The great opus by Milton Friedman and Anna Schwartz – The Monetary History of the United States – has been left to gather dust.

Mr Bernanke no longer pays attention to the M3 data. The bank stopped publishing the data five years ago, deeming it too erratic to be of much use.

This may have been a serious error since double-digit growth of M3 during the US housing bubble gave clear warnings that the boom was out of control. The sudden slowdown in M3 in early to mid-2008 – just as the Fed talked of raising rates – gave a second warning that the economy was about to go into a nosedive.

Mr Bernanke built his academic reputation on the study of the credit mechanism. This model offers a radically different theory for how the financial system works. While so-called “creditism” has become the new orthodoxy in US central banking, it has not yet been tested over time and may yet prove to be a misadventure.

Paul Ashworth at Capital Economics said the decline in M3 is worrying and points to a growing risk of deflation. “Core inflation is already the lowest since 1966, so we don’t have much margin for error here. Deflation becomes a threat if it goes on long enough to become entrenched,” he said.

As Sarah Palin might say; “How’s that creditism working out for ya?”

Looks like Tim Congdon is the Michael Belongia of the UK.  I’m not a pure monetarist, but I’ll take M3 over creditism any day.

The man who revealed too little

Time for one more stab at QE, and then we’ll have a bit of (I hope) good natured fun with my favorite target in the blogosphere.

Paul Krugman has a new piece on the problems with QE, in both Japan and Britain.  As usual, I agree with much of what he has to say, but have a slightly different take on things:

Actually, this has a moral beyond not to worry about inflation. It’s also a reminder that it’s hard to make monetary policy effective in a liquidity trap. There are some writers who suggest that all we need is more determination on the part of Bernanke et al; while I dearly wish the Fed would try harder, it’s not all that easy, because just pushing out money doesn’t do anything. You either have to buy lots of long-term assets “” we’re talking multiple trillions here “” or credibly commit not just the current FOMC, but future FOMCs, to pursuing higher inflation targets.

I agree that the key is expectations; if you don’t commit to higher inflation, you won’t get results from QE.  But I’m not sure this makes monetary stimulus hard to do.  Take a look at the graph he provides (and his comment after on the effects of QE):


Hmm. Deflation just kept on going.

Yes and no. The policy does get CPI inflation up to near zero percent during 2003-08.  The deflator keeps falling, but my hunch is that the BOJ cares more about the CPI.  Also note that unlike the Fed, which has a 2% inflation target, the BOJ has a target of zero inflation.  I think you can make an argument that the policy succeeded, in the sense that they got the inflation rate they wanted.  (Of course recent Japanese inflation has again fallen short of target, just as in most other countries.)  Why do I think that the BOJ succeeded in its own terms?  Because they acted like they had succeeded.  Note the big drop in the monetary base in 2006 (below).  Things like that don’t just happen for no reason.  Krugman doesn’t discuss the decline, but I think the reason for the fall is fairly clear, indeed it is easily explained by Krugman’s own model of the liquidity trap.


Even more angry bears

Now there are two.  First a quick reply to Mike Kimel
Den ganzen Beitrag lesen…

Is the euro crisis real or nominal?

The answer is both.  But I think the nominal aspect may be greater than people realize.  First let me concede that there are severe real problems in the heart of the eurozone.  Here is Wolfgang Munchau:

What is the size of the problem? International Monetary Fund estimates suggest that the eurozone is well behind the US in terms of writing off bad assets. I have heard credible reports suggesting that the underlying situation of the German Landesbanken is even worse than those estimates suggest. Last year, a story made the rounds in Germany, according to which a worst-case estimate would require write-offs in the region of €800bn – about a third of Germany’s annual GDP. If you were to add this to Germany’s public debt, you might jump to the conclusion that Greece should bail out Germany, not the other way round. While that is probably a little exaggerated, there are serious questions about whether the eurozone is still in a position to issue such massive guarantees. So, given what happened to those subprime CDOs, what hypothetical rating should we then attach to that €440bn eurozone SPV? A triple A?

By they way, I found this in an excellent Arnold Kling post, which also links to a rather astounding aspect of our new health care bill.
Den ganzen Beitrag lesen…