Archive for the Category Cognitive illusions


Hindsight is 20-20 (at best)

Update:  I see Matt Yglesias beat me to it.

Before criticizing a Paul Krugman post let me praise his recent post on the Chinese yuan.  I completely agree that the press is overplaying the IMF’s decision to make it a reserve currency.  I did see one report that this might push the Chinese to do more financial reforms, which would be fine.  But countries don’t benefit from reserve currency status anywhere near as much as the media would lead you to believe.

In an earlier post Krugman unintentionally insults Dean Baker:

It’s true that Greenspan and others were busy denying the very possibility of a housing bubble. And it’s also true that anyone suggesting that such a bubble existed was attacked furiously — “You’re only saying that because you hate Bush!” Still, there were a number of economic analysts making the case for a massive bubble. Here’s Dean Baker in 2002. Bill McBride (Calculated Risk) was on the case early and very effectively. I keyed off Baker and McBride, arguing for a bubble in 2004 and making my big statement about the analytics in 2005, that is, if anything a bit earlier than most of the events in the film. I’m still fairly proud of that piece, by the way, because I think I got it very right by emphasizing the importance of breaking apart regional trends.

So the bubble itself was something number crunchers could see without delving into the details of MBS, traveling around Florida, or any of the other drama shown in the film. In fact, I’d say that the housing bubble of the mid-2000s was the most obvious thing I’ve ever seen, and that the refusal of so many people to acknowledge the possibility was a dramatic illustration of motivated reasoning at work.

I hear this claim over and over again, and just don’t understand it.  First let’s consider the Baker claim that 2002 was a bubble.  As the following graph shows, US housing prices are higher than in 2002, even adjusted for inflation.  In nominal terms they are much higher.  So the 2002 bubble claim turned out to be completely incorrect. Krugman needs to stop mentioning Baker’s 2002 prediction, which I’m sure Baker would just as soon forget.

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Of course prices then rose much higher, and are still somewhat lower that the 2006 peak, especially when adjusting for inflation. So I can see how someone might claim that 2006 was a bubble (although I don’t agree, because I don’t think bubbles exist.)

But here’s what I don’t get.  Krugman says it was one of the “most obvious” things he’d ever seen.  That’s really odd.  I looked at the other developed countries that had similar price run-ups, and found 11.  Of those 6 stayed up at “bubble” levels and 5 came back down.  If they still reported New Zealand it would have been 7 to 5 against Krugman. How can you claim something is completely obvious, when there is less than a 50-50 chance you will be correct?  If Krugman were British or Canadian he would have been wrong.

But it gets worse.  Almost no one, not even Krugman, thought we’d have a Great Recession. That makes the bubble claim even more dubious.  Does anyone seriously believe that the utter collapse of the Greek economy has nothing to do with the decline in Greek house prices?  That it’s all about bubbles bursting, with no fundamental factors at all?  That seems to be the claim of the bubble mongers. Even in the US, at least a part of the decline was due to the weak economy.  No, I’m not claiming all of it, but at least a portion.  Look at France, which held up pretty well despite a double-dip recession.  You can clearly see the double dip in the French house prices, so no one can tell me that macroeconomic shocks like bad recessions don’t affect house prices.

In conclusion, even ignoring the elephant in the room–the Great Recession–Krugman’s claim that a bubble was obvious makes no sense.  Most housing markets didn’t collapse after similar run ups.  Most are still up near the peak levels of 2006, even adjusted for inflation (and significantly higher in nominal terms.)  But add in the Great Recession, and the bubble claim becomes far weaker.

Of all the cognitive illusions in economics, bubbles are one of the most seductive. But I expect more from an economist who usually sees through these cognitive illusions, and did a good job showing the fallacy of the claim that reserve currencies status has great benefits to an economy.

PS.  In case you have trouble reading the graphs, the 5 countries with big drops are the US, Greece, Italy, Spain and Ireland.  The US drop is even more surprising when you consider that our post-2006 macro performance is more like the 6 winners.  So I could have claimed it was 6 to 1 against Krugman, if I’d put in a dummy variable for “PIIGS” status.  Does any bubble-monger know why Australian, British, Belgian, Canadian, French, New Zealand, and Swedish house prices are still close to the same lofty levels as 2006, or even higher?  What’s different about the US that made a collapse “inevitable”?

(Paging Kevin Erdmann.)

PS.  I also have a post on Krugman over at Econlog, in case you haven’t gotten your fill here.

When do the Dems believe in trickle-down?

Here’s my hypothesis:  When it comes to microeconomics the Dems are the “stupid party”.  When it comes to monetary policy, and just about all non-economic areas of public policy, the GOP is the “stupid party”.

How could we tell if I’m right about the Dems?  We know that economics is really, really counterintuitive.  It doesn’t seem logical that imports would be good for the economy, or that price gouging in a natural disaster would be good for consumers, or that regulations banning banks from charging fees on ATMS would be bad for bank consumers.  But they are.

So let’s suppose that Dems are like most people; they are not very good at economics. And we also know that they claim to favor the “little guy” and have contempt for “trickle-down economics”, which is the idea that sound economic policies will also benefit people at the bottom.

If my theory is correct, then you’d expect the Dems to favor trickle down policies whenever there were easily discernible “concrete steps” linking the subsidies for big business with the welfare of the common man.

Thus Dems would oppose a cut in the corporate tax rate, unless competition from overseas started to raise fears of jobs losses.  And even then they’d demand that any cuts in the top rate be offset by the closing of loopholes.  And that’s exactly what we observe.

Most importantly, Dems would favor subsidies for big business that seemed likely to directly create jobs, such as the Ex-Im Bank.  And guess what, there is far more support for the Ex-Im Bank (an almost perfect example of crony capitalism) among Dems than among the GOP.  Even when not at the zero bound, and hence not at a time where there might conceivably be a net gain in employment.  Stupid.

Another example is the GSEs, Fannie and Freddie.  These companies have traditionally been strongly supported by the Dems, despite their outrageous business model and obscene profits, because they were seen as helping the common man buy a house.  (As an aside, a portion of the GOP agrees with the Dems, but that’s because big business owns a portion of the GOP, not for ideological reasons. The GOP ideologues tend to oppose crony capitalism.)

What about the vast range of issues where the Dems oppose sound economic policies? My claim is that those are areas where the “concrete steps” helping the average guy are harder to see.  More counterintuitive.

I conclude that the Dems actually do favor trickle-down economics, when they understand it, they simply don’t have the imagination required to see the vast array of areas where deregulation, privatization, and tax reform would help the average guy. They can’t envision anything beyond concrete steps.

The current Ex-Im dispute is the “tell” that lets us see into the mind of Dems, to understand what’s actually motivating their supposed “anti-business” worldview.

Update:  A few additional points, based on some of the comments.  Some seemed to think this post was in some way defending the GOP.  It’s far more critical of the GOP than the Dems.  Take another look.  People are also confused about “trickle down economics”.  AFAIK no one ever advocated trickle down economics.  I assumed everyone knew that.  The title of the post was a joke.  “Trickle down” was a term of derision used against some of the early neoliberal policy reform advocates such as Art Laffer and Jack Kemp, who claimed that deregulation, privatization and cuts in high marginal tax rates would help everyone, including the poor.  Again, no one actually advocated trickle down, it was a term of derision by those who didn’t understand neoliberalism, who could not fathom how conservatives could actually believe that supply-side policies would help the poor.  So they simply imagined that conservatives must believe in “trickle down”, which (AFAIK) no one believes. Why else would they favor tax cuts for the rich?

One criticism I do agree with is that this post is stupid.  All my posts on politics are stupid.  Indeed all articles on politics not written by Scott Alexander are stupid. Talking about politics immediately lowers your IQ by 25 points.  That’s why Tyler rarely writes on politics, he’s too smart to write stupid things.

And yes, the previous paragraph is also stupid, sort of.

Fed meeting today.  Daniel Reeves sent me the following movie posters:

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The problem with “existing store sales”

Quick follow up to my previous post.  Some commenters seem confused about the distinction between existing retailers and new retailers.  New retailers can have a dramatic impact on growth rates, even if a small part of the total.  For simplicity, assume that 94% of the Chinese retail sector is more than year old, and 6% is comprised of new brick and mortar retailers. (Many retailers in China are small family firms, and the country is urbanizing rapidly.)  Also assume that the growth rate of sales at existing brick and mortar retailers (plus those that closed down) is 0%. The growth rate of online is 33% and they comprise 15% of retail.  The new firms might not seem to be a big enough share of the market to dramatically impact the overall growth rate.  In fact, if new firms are 6% of the market, then their contribution to retail sales growth would also be 6%, as (by assumption) they were zero percent of the market one year earlier.

I’d guess that about 5% of China’s 11% retail growth is from online firms, another 6% from new firms, and essentially zero from existing firms.  (That’s based on information in a recent Tyler Cowen post that suggests existing retailer sales are flat.)

I’m sticking with my 6% RGDP forecast for 2016.

Off topic, suppose markets are OK with 1/8% but not 1/4%. How should they respond if this is the Fed’s strategy?

At VTB, global strategist Neil MacKinnon says a 1/8 percentage point increase — which would be the first such move since December 1986 — should be accompanied by a signal from Chair Janet Yellen that the Fed will act again in October if the initial shift has proved acceptable to markets.

And are all Cretans still liars?

Seeing Lu Mountain

Brad DeLong has a post discussing a debate between Paul Krugman and Roger Farmer:

I find myself genuinely split here. When I look at the size of the housing bubble that triggered the Lesser Depression from which we are still suffering, it looks at least an order of magnitude too small to be a key cause. Spending on housing construction rose by 1%-age point of GDP for about three years–that is $500 billion. In 2008-9 real GDP fell relative to trend by 8%–that is $1.2 trillion–and has stayed down by what will by the end of this year be seven years–that is $8.5 trillion. And that is in the U.S. alone. There was a mispricing in financial markets. It lead to the excess expenditure of $500 billion of real physical assets–houses–that were not worth their societal resource cost. And each $1 of investment spending misallocated during the bubble has–so far–caused the creation of $17 of lost Okun gap.

(You can say that bad loans were far in excess of $500 billion. But most of the bad loans were not bad ex ante but only became bad ex post when the financial crisis, the crash, and the Lesser Depression came. You can say that low interest rates and easy credit led a great many who owned already-existing houses to take out loans that were ex ante bad. But that is offset by the fact that the excess houses built had value, just not $500 billion of value. I think those two factors more or less wash each other out. You can say that it was not the financial crisis but the destruction of $8 trillion of wealth revealed to be fictitious as house prices normalized that caused the Lesser Depression. But the creation of that $8 trillion of fictitious wealth had not caused a previous boom of like magnitude.)

To put it bluntly: Paul is wrong because the magnitude of the financial accelerator in this episode cries out for a model of multiple–or a continuous set of–equilibria. And so Roger seems to me to be more-or-less on the right track.

DeLong is certainly right that the housing bust is far too small, but it’s even worse than that.  The vast majority of the housing bust occurred between January 2006 and April 2008, and RGDP actually rose during that period, while the unemployment rate stayed close to 5%.  So it obviously wasn’t the housing bust.  On the other hand you don’t need exotic theories like multiple equilibria—the Great Recession was caused by tight money.  It’s that simple.

Or is it?  Most economists think that explanation is crazy.  They say interest rates were low and the Fed did QE.  They dismiss the Bernanke/Sumner claim that interest rates and the money supply don’t show the stance of monetary policy. Almost no one believes the Bernanke/Sumner claim that NGDP growth and/or inflation are the right way to evaluate the stance of policy.  Heck, even Bernanke no longer believes it.

And even if I convinced them that money was tight they’d ask what caused the tight money, or make philosophically unsupportable distinctions between “errors of omission” and “errors of commission.”

In previous blog posts I’ve pointed out that it’s always been this way.  If in 1932 you had said that tight money caused the Great Depression, most people would have thought you were crazy.  Today that’s the conventional wisdom.  If in the 1970s you’d claimed that easy money caused the Great Inflation, almost everyone except a few monetarists would have said you were crazy.  Now that’s the conventional wisdom.  Even the Fed now thinks that it caused the Great Depression and the Great Inflation.  (Bernanke said, “We did it.”)

The problem is that central banks tend to follow the conventional wisdom of economists.  So when central banks screw up, the conventional wisdom of economists will never blame the central bank (at the time); that would be like blaming themselves. They’ll invent some ad hoc theory about mysterious “shocks.”

The other night at dinner my wife told me that the Chinese sometimes say, “If you cannot see the true shape of Lu Mountain, it’s because you are standing on Lu Mountain.”

In modern conventional macro, most people look at monetary policy from an interest rate perspective.  That means they are part of the problem.  They are looking for causes of the Great Recession, not understanding that they (or more precisely their mode of thinking) are the cause.

Only the small number of economists who observed Mount Lu from other peaks, such as Mount Monetarism or Mount NGDP Expectations, clearly saw the role of central bank policy.  People like Robert Hetzel, David Beckworth, Tim Congdon, etc.

PS.  Before anyone mentions the zero bound, consider two things:

1.  The US was not at the zero bound between December 2007 and December 2008 when the bulk of the NGDP collapse occurred, using monthly NGDP estimates.

2.  Do you personally support having the Fed use a policy instrument that freezes up exactly when you need it most desperately?  Or might the problem be that they’ve chosen the wrong instrument?

PPS.  Yes, not everyone on Mount Monetarism saw the problem, but as far as I know no one on Mount Interest Rate got it right.  Perhaps Mount Interest Rate is Lu Mountain.

PPPS.  To his credit, Brad DeLong thought the Fed should have promised to return NGDP to the old trend line.  If they’d made that promise there would have been no Great Recession, just a little recession and some stagflation.

Xenophobia plus cognitive illusions = mass ignorance

Don’t be offended by the title of this post.  I’d guess 99.9999999% of people don’t understand currency manipulation or quantum mechanics.  So I’m using the term ‘ignorance’ loosely. And of course since I’m in the tiny minority (of seven people, based on the percentage above), there’s always the small chance that I’m the stupid one.  This post is to organize my thoughts, as I’m going to be interviewed on “currency manipulation” tomorrow.

Let’s start with the term ‘currency manipulation.’  That’s what central banks do.  They manipulate the nominal value of currencies.  Period. End of story.  On the other hand:

1.  Monetary policy has no long run effect on real exchange rates.  Once wages and prices adjust, real exchange rates go back to their equilibrium values.

2.  In the short run, central banks can reduce real exchange rates via easy money, however . . .

a.  There is little evidence that this creates a more “favorable” trade balance, for standard income and substitution effect reasons.

b.  The term “favorable” is misleading, as trade surpluses do not steal jobs from other countries, they do not depress AD in other countries, for standard monetary offset reasons.

3.  Real and nominal exchange rates are so different that they should not even be covered in the same course.  And yet 99% of the discussion of exchange rates doesn’t even make clear which concept is being discussed.

4.  Currencies can be manipulated equally well under fixed and floating exchange rates.  That distinction has no importance for any policy issue that I know of.  The fact that a country “pegs” an exchange rate doesn’t mean it manipulates it, except in the sense that all central banks manipulate the value of their currencies.

5.  Many people focus on long run chronic current account (CA) surpluses, and regard those currencies as “undervalued”.  If that’s your concern then you should focus on the real exchange rate, as the nominal exchange rate doesn’t matter in the long run.  (Here I’m thinking about complaints of chronic CA surpluses in Germany, China, Japan, etc.)

6.  There is no theoretical justification for assuming that long term CA surpluses imply undervalued currencies.  None.  At the cyclical frequency there is a Keynesian argument against CA surpluses, which I regard as beyond lame, bordering on preposterous.  But for long run surpluses in China or Germany, there is no argument at all.  The idea that CA surpluses help a country “develop” is laughable.

7.  Monetary policy can’t generate a “undervalued currency” in the long run.  It’s not clear if any government policy could, but the best argument would be that pro-saving policies could lead to lower real exchange rates and CA surplus.

8. This means that in the long run it makes no difference whether a country has its own currency or not. Germany and the Netherlands can “manipulate” their real exchange rate just as easily as Britain, even though they lack their own currency.  They can do so (if at all) by implementing pro-saving policies.

9.  Any pro-saving policy will do, it makes no difference whether the government buys foreign bonds, domestic bonds, or domestic stocks.  If Germany stops taxing capital gains, that will boost domestic saving.  If Singapore and Norway create sovereign wealth funds for future retirees, that’s pro-saving.  And of the PBoC buys lots of Treasuries bonds at a fixed currency peg, that’s pro-saving.  It’s impossible to say that one country “manipulated” its currency more than the other.  But that doesn’t stop 99.9999999% of people, including most economists, from pointing at China.

So basically nobody knows what currency manipulation is, or how to identify it. Almost no one understands the crucial difference between real and nominal exchange rates. No one seems to understand that all central banks manipulate nominal exchange rates, and in the short run, real exchange rates.  No one understands that currency manipulation has nothing to do with fixed vs. floating rates.  No one understands that (in the long run) eurozone countries can manipulate their currencies (real exchange rate) just as easily as countries with their own central bank.  No one understands that currency manipulation may not even affect the CA in the short run, or that changes in the CA don’t affect AD in other countries.

And yet there is room for hope!  Despite this tale of woe, all is not lost. It turns out that complainers are paper tigers.  Countries are often falsely accused of currency manipulation, but no one ever does anything about it.  Is that because they secretly know I’m right?  Don’t make me laugh.  They are cowards, thank God.  The Great Depression and WWII made countries more passive.  I hope they stay that way.

PS.  The real exchange rate is the nominal rate (value of domestic currency) times the domestic price level, divided by the foreign price level.

PPS.  Do I still believe in the wisdom of crowds, despite 99.9999999% being wrong? You bet I do!  I believe that if the Fed “manipulates” the dollar lower at the next FOMC meeting, foreign stock markets will rise, despite our “beggar thy neighbor” policy. People are stupid but markets are very, very wise.