One of my favorite commenters (although we often disagree) is Statsguy.  Tyler Cowen has just called his guest post over at Baseline Scenario a “must-read post.”  Here’s Statsguy:

My primary contention below is that many of these measures used in the composite Heritage Index have nothing to do with less government, and a lot more to do with good government. It is these measures of good government that correlate to economic growth and drive the overall correlation between the “Freedom Index” and positive outcomes. Secondarily, I will argue that many of the other items in the index (like investment freedom) are not causes of growth, but rather outcomes of growth.

I also like the post.  Although I left a comment, I thought it might be useful to repeat the comment here, where more people will see it:

Nice post Statsguy, I mostly agree. It is widely known that richer countries tend to have much bigger governments than poorer countries.  Among really poor countries few people pay income taxes, and it’s hard to collect a lot of revenue. Of course there are exceptions-Brazil has a pretty big government. It’s also true, FWIW, that among rich countries the very richest (Singapore, HK, USA, Australia, Canada, Switzerland, etc) tend to have somewhat smaller governments than the next tier. Norway is an exception.)  My hunch is that the same civic-mindedness that helps countries set up what you call “good government” also tends to lead countries to set up big welfare states (think Denmark.) I believe that in time the Singapore approach to social insurance will be shown to be better.  But despite my right-wing reputation, I regard Denmark and Sweden as highly successful countries.

Tyler Cowen also linked to a very good post at quantoid.

Using the carpentry metaphor, the Heritage Foundation is taking 9 measurements (or 10 depending on the year) to make a single cut. That is, they are using the 10 variables above to produce a single estimate of the economic freedom in every country. A relatively simple investigation shows that both the Fiscal Freedom and Government Spending variables are very poor indicators of economic freedoms and using them will actually produce less accurate estimates of economic freedom. Imagine a very earnest carpenter who takes 10 measurements in order to make precisely the right cut. However, for two of the measurements he was distracted and instead of writing down 12.3 and 12.2 inches, he writes down 21.3 and 21.2 inches. Averaging the 10 measurements will provide a much worse cut than averaging the 9 measurements that were appropriately recorded. I am not arguing that Government Spending and Fiscal Freedom were mis-measured, only that using these will produce a less accurate measure of economic freedom. Technical details of the statistical procedures, theoretical models and investigation that lead to this finding are [here].

I agree that the best way to measure economic freedom is with the 8 non-size of government categories, and when I did this a few years ago I also found Denmark to be the most free market economy.  I prefer the term ‘laissez-faire’ for the small government model measured by Heritage (using all 10 categories) and ‘neoliberal’ for the model of free markets plus social insurance (such as Denmark.)

BTW, In my various recent posts on neoliberalism I took the shortcut of occasionally using the Heritage numbers for all 10 categories, knowing full well that the 8 category subset would have been better.  But I’ve worked with these numbers enough to know that none of my generalizations in those posts would have changed much with the more appropriate figures (which I didn’t have at my fingertips.)

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.”

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.

Now there are two.  First a quick reply to Mike Kimel. 
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