Archive for the Category Rational Expectations


Today’s Nobel Prizes

It was announced today that Christopher Sims and Thomas Sargent will be awarded the Nobel Prize in economics.  A number of bloggers have discussed their contributions, with MarginalRevolution leading the pack.  I don’t keep up with the field enough to provide a comprehensive overview, but I thought I’d provide a few remarks:

1.  I was shocked to hear that Sargent won, because I’d assumed he must have already won the award years ago.  Sargent and Wallace did a lot of important work integrating rational expectations into monetary economics back in the 1970s and early 1980s.  This work may have contributed to Krugman’s paper on expectations traps.  I often argue that if we do eventually get high inflation, the cause will most likely be tight money over the past few years.  That argument comes directly from this paper by Sargent and Wallace.

2.  The Swedish academy provided a short paper explaining some of the contributions of each winner, and I thought I’d make a few comments on impulse response functions and VARs, since those innovations (due mostly to Sims) are being singled out as particularly important:

The difference between forecast and outcome – the forecasting error – for a specific variable may be regarded as a type of shock, but Sims showed that such forecasting errors do not have an unambiguous economic interpretation. For instance, either an unexpected change in the interest rate could be a reaction to other simultaneous shocks to, say, unemployment or inflation, or the interest-rate change might have taken place independently of other shocks. This kind of independent change is called a fundamental shock.

The second step involves extracting the fundamental shocks to which the economy has been exposed. This is a prerequisite for studying the effects of, for example, an independent interest-rate change on the economy. Indeed, one of Sims’s major contributions was to clarify how identification of fundamental shocks can be carried out on the basis of a comprehensive understanding of how the economy works. Sims and subsequent researchers have developed different methods of identifying fundamental shocks in VAR models.

This certainly sounds like a promising approach, and yet I’ve always been skeptical about its practical applicability.  To be honest, I don’t know if my objections hold water, perhaps some commenters can let me know.

When impulse response functions are estimated for monetary shocks, they typically show tight money leading to a near term reduction in output, lasting for several years.  They also show no near term impact on prices, with a slight decline after about 18 months (although it’s not clear if the results are statistically significant.)

I have several problems with this approach.  Researchers often use changes in the monetary base or (more often) interest rates as indicators of monetary shocks.  I don’t find these to be reliable indicators.  They also use macro data such as the Consumer Price Index, which I view as not only highly inaccurate, but systematically biased over the business cycle.  If monetary shocks are misidentified, then you have big problems.  For instance, are higher interest rates tight money, or a reaction to higher NGDP growth expectations?

I’ve noticed that when we do have massive and easily identifiable monetary shocks, as in 1920-21, 1929-30, and 1933, output seems to respond almost immediately to the shock, as does prices.  This makes me wonder about those impulse response functions.  Why would severe monetary shocks immediately impact prices, whereas mild monetary shocks only impact prices after 18 months or more.  That doesn’t seem intuitively plausible, but perhaps I’m missing something here.

Perhaps VAR models are misidentifying monetary shocks.  I’d argue we saw a severe negative monetary shock in the second half of 2008, and that this caused both prices and output to decline significantly between mid-2008 and mid-2009.  What do VAR models show?  Do they correctly identify this contractionary monetary shock?  If not, is there any way of telling why not?  What variables might have given off a misleading reading?

3.  Paul Krugman recently made this argument:

Most spectacularly, IS-LM turns out to be very useful for thinking about extreme conditions like the present, in which private demand has fallen so far that the economy remains depressed even at a zero interest rate. In that case the picture looks like this:

Why is the LM curve flat at zero? Because if the interest rate fell below zero, people would just hold cash instead of bonds. At the margin, then, money is just being held as a store of value, and changes in the money supply have no effect. This is, of course, the liquidity trap.

And IS-LM makes some predictions about what happens in the liquidity trap. Budget deficits shift IS to the right; in the liquidity trap that has no effect on the interest rate. Increases in the money supply do nothing at all.

That’s why in early 2009, when the WSJ, the Austrians, and the other usual suspects were screaming about soaring rates and runaway inflation, those who understood IS-LM were predicting that interest rates would stay low and that even a tripling of the monetary base would not be inflationary. Events since then have, as I see it, been a huge vindication for the IS-LM types

I certainly agree about the lack of inflation resulting from the tripling of the base, which I also predicted, but I don’t see it as having much to do with the shape of the LM curve.  Indeed Sargent and Wallace (1973) provide a much clearer explanation; the Fed publicly announced that the monetary injections would be temporary (although you could also view the IOR program as an explanation.)

Here’s why I don’t like IS-LM.  Suppose the Fed had instead announced that the tripling of the base would be permanent.  What does the IS-LM model predict?  Notice the LM curve is flat, which means the variable on the vertical axis is the nominal interest rate.  But saving and investment depend on real interest rates.  A tripling of the base that was expected to be permanent, would lead to a large increase in inflation expectations—probably to double digit levels.  This would shift the IS curve far to the right, to where it intersected the LM curve at a positive interest rate.  Easy money would make interest rates rise.

So there is no liquidity “trap,” just a promise by the Fed not to allow significant inflation, which they have kept.  From the Fed’s perspective, and even more so from the ECB’s perspective, it’s mission accomplished—inflation has stayed low.  So IS-LM doesn’t show that monetary policy “doesn’t work,” because it has worked out exactly as the Fed hoped; no breakout in inflation expectations.  Some people are under the illusion that the Fed tried to create higher inflation and failed.  But Bernanke explicitly indicated that he was very opposed to a 3% inflation target.  People need to pay more attention to the Fed’s announced objectives, as those objectives are a major cause of the Great Recession.  And Sargent and Wallace help us to understand why.

PS.  I do not favor having the Fed announce that monetary injections will be permanent.  Rather I favor an announced target trajectory for NGDP (or prices), with level targeting.  This would implicitly mean that the Fed was promising enough of the injections would be permanent to hit the nominal target in the future.

January 3, 2001

In recent years I have mostly taught Monetary Economics.  I spend precisely zero minutes covering IS/LM, and lots of time covering market responses to Fed announcements.  Based on some of the comments I received from my last post, I thought it might be interesting to examine one of my favorite Fed announcements, the surprise 1/2 rate cut of January 3, 2001.  This was the first rate cut of the 2001 recession, and reduced the fed funds target from 6.5% to 6.0%.  Here were some market reactions:

1.  The S&P 500 soared by 5.0%

2.  T-bill prices rose by 1/32  (yields fell)

3.  28 year TIPS prices fell by 16/32  (yields rose)

4.  28 year T-bond prices plunged by 76/32 (yields rose sharply)

I generally attribute the slight fall in T-bill yields to the liquidity effect, the rise in stock prices and TIPS yields to the income effect, and the sharp rise in T-bond yields to the income and expected inflation effects.  IS/LM says easy money lowers rates.  I say it is much more complicated than that.

I know I am in the minority, because here’s how the Wall Street Journal (1/4/01) described the market reaction:

Treasury Prices Plummet as Stock Prices Soar on Earlier than Expected Fed Interest Rate Cut

.   .   .  “Market participants were remembering history: that when the Fed’s on your side, stocks are the place to be,” said Mark McQueen, executive vice president of Sage Advisory Services.

Traders said the selling in bonds also reflected the fact that the market had been anticipating an easing of Fed policy soon and already had rallied strongly on the expectation.  When the Fed actually cut rates, people were, in bond market terms, “selling the fact.”

Have you noticed that when reporters don’t have a clue as to what is going on, they attribute it all to market irrationality?  No wonder there’s so much hostility to the efficient markets hypothesis.  Reporters are taught that easy money leads to lower interest rates.  When the markets behave in seemingly irrational ways, the natural reaction is to blame the EMH.  Readers of this blog know that easy money often leads to higher long term interest rates, so we don’t have to resort to market irrationality to explain these reactions to Fed announcements.

Some commenters noted that yesterday’s complex bond market reaction reflected changes in the proportions of maturities that the Fed was likely to purchase.  Maybe so, but in qualitative terms the reaction really wasn’t much different from January 2001, a policy move associated with virtually no bond purchases.  (During normal times the level of excess reserves is tiny and the Fed buys only an infinitesimal amount of bonds when it eases policy.)

Of course most Fed moves are widely expected, and elicit no market reaction.  For instance, the Fed did a long series of quarter point increases between 2004 and 2006, which the market took in stride.  The biggest reactions occur at key points in the business cycle, when a significant change in policy is contemplated.

The next key policy move occurred in September 2007, when the Fed did its first rate cut of this cycle.  Again, the cut was larger than expected (1/2 point), and once again short term rates fell and long term rates rose.  Stocks rose a couple percent after the announcement.  Asian stocks soared on the news. (Sound familiar?)

In December 2007, the fed funds futures market showed the cut would be either a quarter or a half point.  The actual 1/4 point cut caused a severe stock price decline.  This time the income effect stretched all the way down to three months, as yields fell from 3 months to 30 years.  And remember, these rate cuts were responding to a contractionary surprise, so the IS/LM model says yields should have risen.  The stock and bond markets turned out to be prescient.  A recession began at exactly that moment, and by January the Fed realized it had blown it.  It did two rates cuts totaling 125 basis points within 2 weeks, which validated the earlier T-bill market reaction in December.

This was enough to prop up NGDP for another 6 months.  But between July and December 2008 NGDP went into free fall, as the Fed became mesmerized by commodity inflation and failed to respond to abundant signs that NGDP growth was plummeting.  Then they became obsessed with the banking crisis.  Indeed the great collapse of July-Dec. 2008 was more than half over before the Fed started doing monetary policy, and the first move was not a rate cut but rather the interest on reserves program of October 2008—a highly contractionary move!

Lessons for the Fed?  Pay attention to markets that provide information about future NGDP growth, and don’t ever let NGDP expectations going 1, 2, and 3 years out collapse to a level far below trend.  And don’t assume that low rates mean easy money.

The Chicago coup

I already commented on this Paul Krugman post, but I thought of another angle that seems kind of odd.  See what you guys think.  Krugman was commenting on this statement by Laurence Meyer:

There’s also another tradition that began to build up in the late seventies to early eighties””the real business cycle or neoclassical models. It’s what’s taught in graduate schools. It’s the only kind of paper that can be published in journals. It is called “modern macroeconomics.”

I found this confusing, as it wasn’t clear where Meyer put new Keynesianism, which is surely the dominant macro paradigm in the last 30 years.  Paul Krugman also seemed a bit perplexed, and offered this interpretation:

My first reaction, on reading this, was to say that Meyer overstates the case “” and he does, a bit. It has been possible to publish New Keynesian models in the journals, and these models do, I think, provide some useful guidance “” if only as a consistency check on more ad hoc approaches.

But fundamentally Meyer is right. And it has been going on a long time. By the early 1980s it was already common knowledge among people I hung out with that the only way to get non-crazy macroeconomics published was to wrap sensible assumptions about output and employment in something else, something that involved rational expectations and intertemporal stuff and made the paper respectable. And yes, that was conscious knowledge, which shaped the kinds of papers we wrote.

When I left Wisconsin for Chicago in 1977, some of my professors suggested that it was a rather nutty place.  Most schools were Keynesian in 1977, only Chicago and a few others (Rochester, Minnesota, etc) dissented from this orthodoxy.  Certainly the elite Ivy League universities that dominated the field were not sympathetic to Chicago.

Here’s what I’d like to know.  How was it that just a few years later it was almost impossible to get anything published without assuming rational expectations, efficient markets, etc.  I’d like to offer two hypotheses:

1.  Sometime around 1980 an elite team of Chicago macroeconomists stormed the offices of all the major economics journals with AK-47s, ousting all the editors and replacing them with inferior people who just happened to have studied under Lucas and Fama.  Call it the academic equivalent of the Chilean coup.

2.  The discovery of rational expectations and the efficient market hypothesis at the University of Chicago caused a scientific revolution.  A paradigm shift.  Economists began to realize that the expectations assumed in a model ought to be consistent with the model’s predictions.  That it made no sense to have models that assume the world works one way, and populate it with people who believe the world works in an entirely different way.  And economists also realized that it made no sense to build models that implied it was easy to set up mutual funds that would out-perform an indexed fund, simply by following the implications of a model.  After all, it’s really hard to beat indexed funds, despite the fact that lots of very smart people try hard to do so.

So which view seems more plausible?

I hope I haven’t unfairly stacked the deck by presenting only these two hypotheses.  I’ve tried to present both views in an even-handed way.  Please let me know what you think.  (I don’t doubt that readers will provide a third hypothesis in the comment section.)

HT:  Matt Yglesias

PS,  I recall that Yglesias is highly critical of conservatives who reject the scientific consensus on global warming.  I agree.  But I wonder how he feels about liberals who reject the economic consensus about rational expectations and efficient markets.  Krugman says you can’t get published without assuming ratex—doesn’t that sound a lot like climate science, where it’s almost impossible to get published without assuming global warming?  (And don’t say economics is a soft science where proof is difficult to achieve.  Prediction is also difficult in climate science; and for the same reason—both the economy and the climate are very complex.)

Does modern macro rely too much on Ratex and EMH?

This post was motivated by the following comment in a recent Paul Krugman post:

By the early 1980s it was already common knowledge among people I hung out with that the only way to get non-crazy macroeconomics published was to wrap sensible assumptions about output and employment in something else, something that involved rational expectations and intertemporal stuff and made the paper respectable. And yes, that was conscious knowledge, which shaped the kinds of papers we wrote. So you could do exchange rate models that actually had realistic assumptions about prices and employment, but put the focus on rational expectations in the currency market, so that people really didn’t notice. Or you could model optimal investment choices, with the underlying framework fairly Keynesian, but hidden in the background. And so on.

I can’t quite tell whether Krugman thinks “rational expectations and intertemporal stuff” are counterproductive, so the following isn’t really aimed at Krugman, but rather the many economists who I am quite certain do regret the influence of ratex and the efficient markets hypothesis.

The most important macro event of my lifetime was the precipitous drop in inflation and NGDP growth expectations during the late summer and early fall of 2008.  Because inflation had been running around 5% over the previous year, antique macro models based on adaptive expectations were completely useless during this period.  Indeed, I’m guessing that one of the reasons why the Fed was behind the curve in the fall of 2008 was precisely because their models were far too backward-looking.  During the financial crisis Fed policy got effectively tighter and tighter, and as a result there was a whole lotta “rational expectations and intertemporal stuff” going on.

Here’s what I find so ironic.  Everyone talks about how the profession became obsessed with ratex and the EMH after 1980, but from my perspective most economists still seem stuck in the adaptive expectations era.  If you really believed in ratex and the EMH, wouldn’t you be really, really interested in market forecasts of the policy goal variable?  I would be.  Yet instead of trying to infer market forecasts, they built elaborate structural models to try to forecast the goal variables.  In the 1980s when I tried to peddle my futures targeting approach, no one seemed interested.  I presented papers at the AEA meetings, the NY Fed, the Philly Fed, and everyone just yawned.  So from my perspective we face exactly the opposite problem; the profession doesn’t take ratex and the EMH seriously enough.  If the Fed really believed in ratex and efficient markets, they would have put the pedal to the metal in the infamous September 16, 2008 meeting.  Instead they yawned, and left rates unchanged at 2%.

PS.  Perhaps me and the other futures targeting proponents were just ahead of our time.  One famous macroeconomist endorsed futures targeting just recently.  A sign of things to come?

PPS.  Yes, the Fed did use the EMH as an excuse not to intervene in the housing bubble.  But that’s exactly where it was not appropriate.  The existence of FDIC and TBTF means the EMH provides no justification for not regulating bank risk-taking.

Caplan on Keynesianism

Bryan Caplan recently defended the use of introspection in economic analysis:

But what is the source of Keynesians’ self-confidence?  Every Keynesian I’ve ever known has a stock answer: The empirics are on our side.  But when probed, they rarely deliver any details about these empirics.  It’s been three decades since Keynesians could merely point at the Phillips Curve and say, “See?  See?!”  And in terms of merely “fitting the data points,” Prescott infamously showed that a simple RBC model works rather well.

At this point, it’s tempting to dismiss Keynesianism as a dogmatic cult.  But in fact, there are key issues where their self-confidence is well-deserved.  The only problem: They’re too scared to admit why.  So let me answer for them: The source of Keynesian confidence is not “empirics,” but introspection.

When Keynesians study the Great Depression, for example, they don’t pore over “the data” to determine whether or not mass unemployment was voluntary.  They introspect – and correctly conclude that tens of millions of workers didn’t decide to take a ten-year vacation in 1929.  They reject the assumption of perfect wage flexibility on the same basis: Not by staring at “the data,” but by introspecting on the question, “How would human beings react if employers cut their nominal wages by 5%?”

Several things struck me about this post.  First, Keynes himself rejected wage rigidity as a cause of involuntary unemployment.  I agree with Caplan on wage rigidity, but it is interesting that introspection led Keynes in a very different direction.

This is the part of Bryan’s post that most intrigued me:

Of course, once Keynesians admit their real reasons, they do have a little problem: Some of their positions fail the introspective test!  Foremost examples:

1. Keynesians’ preference for fiscal over monetary stimulus contradicts introspection about the interest-sensitivity of money demand.

2. The Keynesian claim that wage cuts reduce Aggregate Demand seems introspectively plausible at first, but only if you neglect everyone but workers who already have jobs.

3. Above all, once you take introspection about nominal rigidity seriously, the obvious response is to swear eternal hostility against every government effort to boost labor costs.  Wages on the free market don’t rise and fall like the stock market, but labor market regulation merely amplifies this defect.  Consistent Keynesians should be championing radical labor market deregulation – not signing petitions to raise the minimum wage.

I’d be very interested in your reaction, but it seems to me that the Keynesian liquidity trap argument is extremely counter-intuitive.  That doesn’t make it wrong, but it suggests that Keynesians shouldn’t be mocking RBC explanations of cycles solely on the grounds that they seem implausible.

To make this example cleaner, I’d like to assume a strongly negative IOR is in effect.  People like Krugman argue that the liquidity trap is not just about banks hoarding reserves; in Japan so much cash was hoarded that safes became a popular consumer durable.  So let’s consider whether we could plausibly get a liquidity trap if we had a negative IOR, which assured that any new base money would go into currency held by the public.  To think about the issue, consider the following equation:

Nominal national income = k*Cash.    Or, k = (cash/nominal national income.)

Update:  Well algebra was never my strength.  Richard pointed out it should be Cash = k*NNI

Can the Fed increase nominal national income when the economy is at the zero bound?  If you don’t think so, then you must believe that people behave as follows:

Suppose the Fed increased cash in circulation by 17%.  If there is no effect on NNI, then the average person would react to the Fed’s action by increasing their “k ratio” by 17%.  The k ratio is the ratio of cash to income.  So if you had an income of $100,000, and you held cash of $1000, your k ratio would be 1%.  This is a variable that is obviously under your control.  You choose your k ratio.  Now we can see what is so amazing about the hardcore Keynesian view of liquidity traps.  They are essentially arguing that if the Fed increases the supply of cash by 17%, the average person will react to that action by increasing their k ratio by 17%.  But why?  Is that how you behave?  Do you watch how much the Fed increases the base, and increase your k ratio by that amount?  Would you respond to the Fed boosting the cash supply by 17%, by increasing your personal cash holdings from $1000 to precisely $1170?  Remember, if you only increase it to $1150, the liquidity trap no longer holds.  I simply can’t imagine any mechanism that would cause people to manage their cash that way.

Except . . . suppose the increase was expected to be temporary.  Then speculators would not expect any significant increase in the price level, because current prices are linked through inter-temporal arbitrage to future prices.  In that case if the public tried to get rid of excess cash balances by spending them on goods, speculators would supply more goods.  All the extra net demand would be for financial assets.  Nominal rates would fall until people were willing to hold this extra cash.  Maybe if T-bill yields fell slightly below zero, then people would hoard cash and put it in safes.  Most people wouldn’t increase their cash holdings by precisely 17%, but some people would hoard vast amounts of cash in response to lower T-bill yields.

Nothing new here, just another reason why the traditional explanation of the liquidity trap is inconsistent with common sense.  You really need to assume that currency injections are temporary.  You can’t get a liquidity trap by positing that people don’t want to borrow at zero rates, or that banks don’t want to lend.  That’s not enough—you need to show why people would hoard the extra cash.  And hoard exactly the amount of cash injected.  And you can’t do that in a way that’s consistent with common sense unless you assume the cash injection is perceived as being temporary.  If people think it’s permanent, the average guy won’t hoard it (Ratex or not) and the savvy investor won’t hoard what the average guy isn’t hoarding, as it’s not a good investment if prices are expected to be higher in the future.  Bernanke doesn’t have to convince the public, just the savvy investors.  And they are already bidding up asset prices fast in anticipation of November 3rd, even without any commitment to a higher nominal target, so it doesn’t look like much convincing is necessary.

PS:  In an earlier post I discussed how in the General Theory Keynes had mischaracterized people like Pigou.  Jim Glass sent me these interesting slides, which contain some evidence on that subject.

PPS.  This post is loosely related to recent Nick Rowe and David Beckworth posts on how the “paradox of thrift” is actually about the hoarding of cash.