Economist's View

Unemployment Insurance and Job Search in the Great Recession

New research from Jesse Rothstein shows that, contrary to what you may have heard from those who are trying to blame our economic problems on government programs rather than malfeasance on Wall Street, unemployment insurance is not the cause of the slow recovery of employment:

Unemployment Insurance and Job Search in the Great Recession, by Jesse Rothstein, NBER Working Paper No. 17534 [open link]: Nearly two years after the official end of the "Great Recession," the labor market remains historically weak. One candidate explanation is supply-side effects driven by dramatic expansions of Unemployment Insurance (UI) benefit durations, to as many as 99 weeks. This paper investigates the effect of these UI extensions on job search and reemployment. I use the longitudinal structure of the Current Population Survey to construct unemployment exit hazards that vary across states, over time, and between individuals with differing unemployment durations. I then use these hazards to explore a variety of comparisons intended to distinguish the effects of UI extensions from other determinants of employment outcomes.

The various specifications yield quite similar results. UI extensions had significant but small negative effects on the probability that the eligible unemployed would exit unemployment, concentrated among the long-term unemployed. The estimates imply that UI benefit extensions raised the unemployment rate in early 2011 by only about 0.1-0.5 percentage points, much less than is implied by previous analyses, with at least half of this effect attributable to reduced labor force exit among the unemployed rather than to the changes in reemployment rates that are of greater policy concern.

NBER Economic Fluctuations & Growth Research Meeting

I am here today:

NATIONAL BUREAU OF ECONOMIC RESEARCH, INC.

EF&G Research Meeting

October 21, 2011

Federal Reserve Bank of Chicago
230 South LaSalle Street
Chicago, Illinois

George-Marios Angeletos and Martin Schneider, Organizers

PROGRAM

THURSDAY, OCTOBER 20:

6:30 pm

Reception and Dinner - Federal Reserve Bank of Chicago

FRIDAY, OCTOBER 21:

9:00 am

Aysegul Sahin, Federal Reserve Bank of New York
Joseph Song, Columbia University
Giorgio Topa, Federal Reserve Bank of New York
Gianluca Violante, New York University
Measuring Mismatch in the U.S. Labor Market

Discussant: Robert Shimer, University of Chicago and NBER

10:00 am - Coffee Break

10:30 am

Cristina Arellano, University of Minnesota and NBER
Yan Bai, Federal Reserve Bank of Minneapolis
Patrick Kehoe, Federal Reserve Bank of Minneapolis, Princeton University, University of Minnesota and NBER
Financial Markets and Fluctuations in Uncertainty

Discussant: Andrea Eisfeldt, UCLA

11:30 am

Raghuram Rajan, University of Chicago and NBER
Rodney Ramcharan, Federal Reserve Board
The Anatomy of a Credit Crisis: The Boom and Bust in Farm Land Prices in the United States in the 1920s

Discussant: Sydney Ludvigson, New York University and NBER

12:30 pm - Lunch

1:30 pm

Per Krusell, Stockholm University and NBER
Toshihiko Mukoyama, University of Virginia
Richard Rogerson, Princeton University and NBER
Aysegul Sahin, Federal Reserve Bank of New York
Is Labor Supply Important for Business Cycles?

Discussant: Marcelo Veracierto, Federal Reserve Bank of Chicago

2:30 pm - Coffee Break

3:00 pm

Eric Sims, University of Notre Dame and NBER
Permanent and Transitory Technology Shocks and the Behavior of Hours: A Challenge for DSGE Models

Discussant: Jonas Fisher, Federal Reserve Bank of Chicago

4:00 pm

Allen Head, Queen's University
Lucy Qian Liu, IMF
Guido Menzio, University of Pennsylvania and NBER
Randall Wright, University of Wisconsin, Madison and NBER
Sticky Prices: A New Monetarist Approach

Discussant: John Leahy, New York University and NBER

Chow: Usefulness of Adaptive and Rational Expectations in Economics

Gregory Chow of Princeton on rational versus adaptive expectations:

Usefulness of Adaptive and Rational Expectations in Economics, by Gregory C. Chow: ...1. Evidence and statistical reason for supporting the adaptive expectations hypothesis ... Adaptive expectations and rational expectations are hypotheses concerning the formation of expectations which economists can adopt in the study of economic behavior. Since a substantial portion of the economic profession seems to have rejected the adaptive expectations hypothesis without sufficient reason I will provide strong econometric evidence and a statistical reason for its usefulness...

2. Insufficient evidence supporting the rational expectations hypothesis when it prevailed The popularity of the rational expectations hypothesis began with the critique of Lucas (1976) which claimed that existing macro econometric models of the time could not be used to evaluate effects of economic policy because the parameters of these econometric models would change when the government decision rule changed. A government decision rule is a part of the environment facing economic agents. When the rule changes, the environment changes and the behavior of economic agents who respond to the environment changes. Economists may disagree on the empirical relevance of this claim, e.g., by how much the parameters will change and to what extent government policies can be assumed to be decision rules rather than exogenous changes of a policy variable. The latter is illustrated by studies of the effects of monetary shocks on aggregate output and the price level using a VAR. Such qualifications aside, I accept the Lucas proposition for the purpose of the present discussion.

Then came the resolution of the Lucas critique. Assuming the Lucas critique to be valid, economists can build structural econometric models with structural parameters unchanged when a policy rule changes. Such a solution can be achieved by assuming rational expectations, together with some other modeling assumptions. I also accept this solution of the Lucas critique.

In the history of economic thought during the late 1970s, the economics profession (1) accepted the Lucas critique, (2) accepted the solution to the Lucas critique in which rational expectations is used and (3) rejected the adaptive expectations hypothesis possibly because the solution in (2) required the acceptance of the rational expectations hypothesis. Accepting (1) the Lucas critique and (2) a possible response to the Lucas critique by using rational expectations does not imply (3) that rational expectations is a good empirical economic hypothesis. There was insufficient evidence supporting the hypothesis of rational expectations when it was embraced by the economic profession in the late 1970s. This is not to say that the rational expectations hypothesis is empirically incorrect, as it has been shown to be a good hypothesis in many applications. The point is that the economic profession accepted this hypothesis for general application in the late 1970s without sufficient evidence.

3. Conclusions This paper has presented a statistical reason for the economic behavior as stated in the adaptive expectations hypothesis and strong econometric evidence supporting the adaptive expectations hypothesis. ... Secondly, this paper has pointed out that there was insufficient empirical evidence supporting the rational expectations hypothesis when the economics profession embraced it in the late 1970s. The profession accepted the Lucas (1976) critique and its possible resolution by estimating structural models under the assumption of rational expectations. But this does not justify the acceptance of rational expectations in place of adaptive expectations as better proxies for the psychological expectations that one wishes to model in the study of economic behavior. ...

NBER Research Summary: The Role of Household Leverage

This NBER Research Summary by Atif Mian and Amir Sufi echoes many of the arguments I've been making about balance sheet recessions. In addition, the authors argue that the trouble in mortgage markets can be traced to a "securitization-driven shift in the supply of mortgage credit," and that "the expansion in mortgage credit was more likely to be a driver of house price growth than a response to it." They also show that "non-GSE securitization primarily targeted zip codes that had a large share of subprime borrowers. In these zip codes, mortgage denial rates dropped dramatically and debt-to-income ratios skyrocketed":

Finance and Macroeconomics: The Role of Household Leverage, by Atif R. Mian and Amir Sufi, NBER Reporter 2011 Number 3, Research Summary: The increase in household leverage prior to the most recent recession was stunning by any historical comparison. From 2001 to 2007, household debt doubled, from $7 trillion to $14 trillion. The household debt-to-income ratio increased by more during these six years than it had in the prior 45 years. In fact, the household debt-to-income ratio in 2007 was higher than at any point since 1929. Our research agenda explores the causes and consequences of this tremendous rise in household debt. Why did U.S. households borrow so much and in such a short span of time? What factors triggered the slowdown and collapse of the real economy? Did household leverage amplify macroeconomic shocks and make a quick recovery less likely? How do politics constrain policy responses to an economic crisis?

While the focus of our research is on the recent U.S. economic downturn, we believe the implications of our work are wider. For example, both the Great Depression and Japan's Great Recession were preceded by sharp increases in leverage.¹ We believe that understanding the impact of household debt on the economy is crucial to developing a better understanding of the linkages between finance and macroeconomics. ...[continue reading]...

Austerity and Anarchy

Via Kevin O'Rourke at The Irish Economy:

Austerity and Anarchy: Budget Cuts and Social Unrest in Europe, 1919-2009, by Jacopo Ponticelli and Hans-Joachim Voth, Discussion Paper No. 8513, August 2011, Centre for Economic Policy Research: Abstract Does fiscal consolidation lead to social unrest? From the end of the Weimar Republic in Germany in the 1930s to anti-government demonstrations in Greece in 2010-11, austerity has tended to go hand in hand with politically
motivated violence and social instability. In this paper, we assemble cross-country evidence for the period 1919 to the present, and examine the extent to which societies become unstable after budget cuts. The results show a clear positive correlation between fiscal retrenchment and instability. We test if the relationship simply reflects economic downturns, and conclude that this is not the key factor. We also analyze interactions with various economic and political variables. While autocracies and democracies show a broadly similar responses to budget cuts, countries with more constraints on the executive are less likely to see unrest as a result of austerity measures. Growing media penetration does not lead to a stronger effect of cut-backs on the level of unrest.

"Animal Spirits, Rational Bubbles and Unemployment in an Old-Keynesian Model"

Roger Farmer:

Animal Spirits, Rational Bubbles and Unemployment in an Old-Keynesian Model, by Roger Farmer, NBER Working Paper No. 17137, June 2011 [open link?]: Abstract This paper presents a model of the macroeconomy in which any unemployment rate may be a steady-state equilibrium and every equilibrium unemployment rate is associated with a different value for the price of assets. To select an equilibrium, I construct a theory in which asset price bubbles are caused by the self-fulfilling animal spirits of market participants, selected by a belief function. In contrast to my earlier work on this topic, asset prices may be unbounded. All of the actors in my model have rational expectations and the asset price bubbles that occur are individually rational, even though the equilibria of the model are socially inefficient. My work opens the door for a new class of theories in which market psychology, captured by the belief function, plays an independent role in helping us to understand economic crises.

"What Should Be Done About the Private Money Market?"

Morgan Ricks argues that we are still vulnerable to runs on the shadow banking system, and that the "moneyness" of assets traded in these markets will require the use of regulatory approaches similar to those used to stabilize the traditional banking system:

What Should Be Done About the Private Money Market?, by by Morgan Ricks: What should be done about the private money market? It is widely recognized that this market was at the center of the recent financial crisis. Indeed, very nearly the entire emergency response to the financial crisis was aimed at stabilizing this market. Yet recent and proposed reform measures have done little to address this market squarely.

It is important to be precise about terminology. The term “private money market” refers to the multi-trillion dollar market for short-term IOUs that are neither issued by nor guaranteed by the federal government. This market includes repurchase agreements (“repo”), asset-backed commercial paper (“ABCP”), uninsured deposit obligations, and so-called Eurodollar obligations of foreign banks. It also includes the “shares” of money market mutual funds. ...

The recent crisis witnessed a massive run on the private money market (also called the “shadow banking system”). And the federal government responded with a massive intervention. But why intervene? What would have been so bad about widespread defaults by issuers of these instruments? In my recent article, Regulating Money Creation After the Crisis, published in the Harvard Business Law Review, I provide one possible answer. Specifically, I argue that the instruments of the private money market have important properties of money. Accordingly, widespread defaults on these instruments should be expected to generate adverse monetary consequences.

This argument echoes Milton Friedman’s and Anna Schwartz’s influential argument about the causes of the Great Depression. In their monumental Monetary History of the United States, they traced the origins of the Great Depression to a massive monetary contraction brought about by the collapse of the banking system. ...

Does the Friedman-Schwartz logic apply to the private money market? The argument is admittedly somewhat counterintuitive. Unlike bank demand deposits, most private money market instruments do not function as a “medium of exchange”—the sine qua non of “money.” Nevertheless, the article offers both theoretical support and empirical evidence for the “moneyness” of money market instruments. It also shows that money market instruments are in fact treated like demand deposit obligations—and differently from ordinary debt instruments—in a variety of legal, accounting, and market contexts. In other words, these instruments are widely acknowledged as having money-like attributes, in a way that ordinary (capital market) debt instruments are not.

This line of reasoning poses a problem for traditional financial regulation. Suppose for the moment that money market instruments do indeed serve an important monetary function. ... Suppose also that defaults on these instruments, like defaults on deposits, amount to a contraction in the money supply, with the attendant macroeconomic consequences that Friedman and Schwartz identified. If these consequences provide a sound economic justification for the extraordinary regulation of depository banks—not to mention the special support facilities to which depository banks have access—does that rationale not apply with equal force to issuers of private money market instruments? In other words, does our special regulatory system for depository firms rest on an arbitrary and formalistic distinction?

My paper argues that it does. More generally, it finds reasons to favor establishing money creation as a sovereign responsibility by means of a public-private partnership system—in effect, recognizing money creation as a public good. (This is just what modern bank regulation has done for decades.) Logically, this approach would entail disallowing access to money market financing by firms not meeting the applicable regulatory criteria—just as firms not licensed as banks are legally prohibited from issuing deposit liabilities.

Against this backdrop, the article reviews the Dodd-Frank Act’s approach to regulating money creation. It finds reasons to doubt that the new law will be conducive to stable conditions in the money market.

The full paper is available for download on the Harvard Business Law Review website here.

Are Working Papers Working?

Should we abandon working papers?:

Working Papers are NOT Working, by Berk Özler: ...It is common practice in economics to publish working papers. There are formal working paper series such as NBER, BREAD, IZA, World Bank Policy Research Working Paper Series, etc. With the proliferation of the internet, however, people don’t even need to use these formal working paper series. You can simply post your brand new paper on your website and violà, you have a working paper: put that into your CV! Journals are giving up double-blind refereeing (AEJ is the latest) because it is too easy to use search engines to find the working paper version (it’s not at all clear that this is good...). But, do the benefits of making these findings public before peer-review outweigh the costs? I recently became very unsure…

In economics, publication lags, even for journals that are fast, can be long: it is not uncommon to see articles that state: Submitted December 2007; accepted August 2010. ... But, research findings are public goods and working papers are a way to get this information out to parties who can benefit from the new information while the paper is under review.

But, that assumes that the findings are ready for public consumption at this preliminary stage. By preliminary, I mean papers that have not yet been seriously reviewed by anyone familiar with the methods and the specific topic. Findings, and particularly interpretations, change between the working paper phase and the published version of a paper: if they didn’t, then we would not need peer-reviewed journals. Sometimes, they change dramatically. ...

When a new working paper comes out, especially one that might be awaited (like the first randomized experiment on microfinance), people rush to read it (or, rather, skim it). It gets downloaded many times, gets blogged about, etc. Then, a year later a new version comes out (maybe it is even the published version). Many iterations of papers simply improve on the original premise, provide more robustness checks, etc.. But, interpretations often change; results get qualified; important heterogeneity of impacts is reported. And sometimes, main findings do change. What happens then?

People are busy. Most of them had only read the abstract (and maybe the concluding section) of the first draft working paper to begin with. ... The newer version, other than for a few dedicated followers of the topic or the author, will not be read by many. They will cling to their beliefs based on the first draft: first impressions matter. ...

There is another problem: people who are invested in a particular finding will find it easier to take away a message that confirms their prior beliefs from a working paper. They will happily accept the preliminary findings of the working paper and go on to cite it for a long time (believe me, well past the updated versions of the working paper and even the eventual journal publication). People who don’t buy the findings will also find it easy to dismiss them: the results are not peer-reviewed. At least, the peer-review process brings a degree of credibility to the whole process and makes it harder for people to summarily dismiss findings they don’t want to believe.

I have some firsthand experience with this, as my co-authors and I have a working paper, the findings of which changed significantly over time. In March 2010, we put out a working paper on the role of conditionalities in cash transfer programs, which we also simultaneously submitted to a journal. The paper was reporting one-year effects of an intervention using self-reported data on school participation. ...

What’s the problem? Our findings in the March 2010 version suggested that CCTs that had regular school attendance as a requirement to receive cash transfers did NOT improve school enrollment over and above cash transfers with no strings attached. Our findings in the December 2010 version DID. ...

However, the earlier (and erroneous) finding that conditions did not improve schooling outcomes was news enough that it stuck. Many people, including good researchers, colleagues at the Bank, bloggers, policymakers, think that UCTs are as effective as CCTs in reducing dropout rates – at least in Malawi. And, this is with good reason: it was US who screwed up NOT them! Earlier this year, I had a magazine writer contact me to ask whether there was a new version of the paper because her editor uncovered the updated findings while she was fact-checking the story before clearing it for publication. As recently as yesterday, comments on Duncan Green’s blog suggested that his readers, relying on his earlier blogs and other blogs, are not aware of the more recent findings. Even my research director was misinformed about our findings until he had to cite them in one of his papers and popped into my office.

Many working papers will escape this fate – which is definitely not the norm. But, no one can tell me that working papers don’t improve and change over time as the authors are pushed by reviewers who are doing their best to be skeptical and provide constructive criticism. But, it turns out that those efforts are mainly for the academic crowd or for the few diligent policymakers who are discerning users of evidence. ...

So, what if we chose to not have working papers? There is no doubt that the speed with which journals publish submitted papers would have to change. ...

If we didn't have working papers, we could also go back to double blind reviews again. No, it won’t be perfect, but double-blind was there for a reason. I see serious equity concerns with single blind reviews ...

Double blind has its problems as well. If you are active at NBER meetings, at a top university, etc., etc., and you get a paper to referee that you haven't already seen presented somewhere (or at least reviewed as as submission to a conference), often more than once, you will draw conclusions. But single blind removes all doubt, so it's no better on this score.

On the issue of working papers, sensational results -- the ones most likely to be costly if they change later -- are going to leak in their preliminary form, and they are going to be reported. When that happens, I'd rather that the experts in the field be aware of the paper already or have easy access to it so that they can qualify the results as needed, or at least try to. Without the checks and balances of other researchers to help reporters and policymakers with the interpretation of the results, etc., this could lead to even worse policy errors than before. More generally, I'm not convinced that the costs -- the times when economics working papers have caused changes in policy that are later regretted -- exceed the benefits to other researchers of having this information available sooner rather than later (if only, for example, to know what questions other people are working on, new techniques that are being used, and so on -- the results themselves are not the only way this information is helpful).

"Using Blackouts to Help Understand the Determinants of Infant Health"

This is based on the work of a new colleague, Alfredo Burlando:

What happens when the power goes out? Using blackouts to help understand the determinants of infant health, by Jed Friedman: Low birth weight, usually defined as less than 2500 grams at birth, is an important determinant of infant mortality. It is also significantly associated with adverse outcomes well into adulthood such as reduced school attainment and lower earnings. Maternal nutrition is a key determinant of low birth weight...

But what about the down-side risk of temporary income fluctuations - do short-lived negative income shocks have equally significant effects on low birth weight? Households may be able to prioritize the consumption and care of pregnant mothers during adverse shocks, but of course households must know about the pregnancy in the first place. This knowledge doesn’t usually manifest until after the first 6-8 weeks of pregnancy and those initial weeks of pregnancy are also critical ones to ensure the health of the fetus. One recent study by Alfredo Burlando focuses on this critical window of time when households do not yet have sufficient knowledge and thus do not sufficiently protect against the changing economic circumstances.

In May of 2008, the undersea cable that brings power to the Tanzanian island of Zanzibar was ruptured, plunging the island into a blackout that lasted 4 weeks. As a result, households employed in sectors such as manufacturing or tourism that relied on electricity experienced income declines while households in more traditional sectors such as farming did not suffer noticeable shortfalls. Fortunately any income decline was short-lived – the power was only out for 4 weeks – and in a matter of months income in all affected sectors had recovered to previous levels. Despite the brief duration of this income shock, could there have been any long-lasting consequences?

Well it turns out that infants born 7 to 9 months after the blackout were significantly smaller – an average of 75 grams smaller – than infants born within 6 months of the start of blackout or beyond 9 months after its end. This reduction translates into an 11% increase in the probability of a low weight birth. Burlando proposes reduced nutritional intake and heightened maternal stress, brought on by the blackout induced income shock, as the main transmission mechanism for lower birth weights. ...

The findings suggest that women who were known to be pregnant at the time of the black out, i.e. those who were visibly pregnant, received insurance from the shock where as women who did not realize they were yet pregnant (or who had conceived during the blackout) did not receive the same protection.

For me, the take away messages from this study are threefold:

• These findings highlight the importance of behavioral responses and that people in the face of a crisis can be resilient when they are armed with relevant knowledge – households with women who knew they were pregnant apparently prioritized maternal nutrition. It also underscores the obvious point that any protective program that targets pregnant women faces the challenge of improving the informational barriers that prevent early pregnancy awareness.
• The study also highlights the long-lasting effects of even very brief income shocks if (a) they occur at critical moments in fetal development and (b) households cannot fully smooth consumption or otherwise insure themselves from temporary declines. ...

"There is Something Very Wrong with This Picture"

I've been meaning to highlight this paper by Levy and Kochan, and still hope to do a bit more with it, but for now here's Dani Rodrik:

There is something very wrong with this picture, by Dani Rodrik: This graph is from a new paper by Frank Levy and Tom Kochan, showing trends in labor productivity and compensation since 1980:

Labor productivity increased by 78 percent between 1980 and 2009, but the median compensation (including fringe benefits) of 35-44 year-old males with high school (and no college) education declined by 10 percent in real terms.

Women have done in general better, but two-thirds of women still have seen their pay lag behind productivity.

Levy and Kochan call for a Social Compact to reverse these trends, and outline some of the steps necessary to get there. The paper is very well worth reading.

Policymakers need to focus on job creation much more than they are, but as this graph shows creating more jobs is only part of the solution to the problems that middle and lower class households have been experiencing. We also need to ensure that income is equitably shared, and the paper outlines the steps needed to move in this direction:

The broken link between productivity and wage growth reflects changes in markets, policies, and their enforcement, institutions, and organizational norms and practices that have been evolving for a long time (circa 1980). Given this history, it is clear that the solutions will also need to be multiple and systemic and sustained for a long time. They also will need to match the features of the contemporary economy. The prior Social Compact was well-suited to a production-based economy in which wage increases in manufacturing set the norm for other parts of the economy.

Today, manufacturing can no longer play this catalytic role. Instead, norms and institutions need to support an innovation-knowledge based economy. We outline below a potential combination of actions suited to this task. If the list seems formidable, recall that we are now facing a situation where the economy has stopped working for something between one-half and two-thirds of all American workers.

Many of us have been calling for a New New Deal. I've done so many times over the last several years and I'm far from alone. Unfortunately, there's very little evidence that this is anywhere near the top of the political agenda. So long as those with wealth and power get theirs (and keep filling campaign coffers), it's hard to see that changing.

Farmer on Williamson on Farmer and Kocherlakota

I asked Roger Farmer if he'd like to respond to a recent post from Stephen Williamson: (it will be helpful to read Williamson's post first):

Farmer on Williamson on Farmer and Kocherlakota: Thanks to Stephen Williamson for publicizing my work and to Mark Thoma for providing a link and invitation to respond. Stephen: in addition to the paper you cited, I just finished an empirical paper on how to explain data without the Phillips Curve, two theoretical papers on why fiscal policy works in the short run (but shouldn’t be used) two papers on rational expectations with Markov switching and a piece on stochastic overlapping generations models.

The papers you mention in your blog, by Narayana and me, were both presented at a conference in Marseilles last week with not one but two Fed Presidents in attendance: Jim Bullard also gave a paper. Jim presented work that draws on the Benhabib-Schmitt-Grohé-Uribe paper on the perils of Taylor Rules. He sees a real danger of a Japan style deflation trap happening in the U.S.. Narayana gave a paper that combines a liquidity trap model of bubbles in an overlapping generations framework with a labor market based on the idea from my 2010 book, Expectations Employment and Prices. This book provides a new paradigm that drops the wage bargaining equation from a labor contracting model and replaces it with the assumption that employment is demand determined. This is the same assumption taken up by Narayana in the paper he presented in Marseilles.

The main idea is explained very nicely by one of the anonymous commentators on Stephen’s blog , who said:

“Think of it this way. With a centralized labor market, the real wage is pinned down by the intersection of labor demand and supply. With search, the labor market need not clear: the labor supply FOC is missing, and we need to add something else to close the model. One thing to add is an explicit bargaining model that effectively pins down the wage. An alternative is to say that output is demand-determined, and that the wage is the marginal product of labor at the demand determined level of output. Then firms are on their labor demand curve, but workers are not on their labor supply curve (but the beauty of search - unemployed workers will take a job at any positive wage).”

That’s exactly right. And once there are many possible labor market equilibria, there is room to close the model by bringing back the role of market psychology. That’s what I do in my work which has room for both involuntary unemployment and animal spirits; the two cornerstones of Keynes’ General Theory that are missing from the macroeconomics that emerged from Samuelson’s interpretation of Keynes.

Stephen professes not to understand the language of aggregate demand and supply. That’s not surprising given how many different ways it’s used. My own preferred interpretation is explained in a piece I wrote for the International Journal of Economic Theory in 2008.

The idea of aggregate demand and supply makes just as much sense as the notion of a microeconomic demand and supply curve as long as one works within a framework where the variables that shift one of the curves do not simultaneously shift the other. That is clearly not true in post-Lucas rational expectations models which is why the language went out of fashion. It is true in my work.

Imagining a Rejection

This is from Tiago Mata at History of Economics Playground. I don't think he likes Robert Shiller's paper on "Economists as Worldly Philosophers," nor the intrusion on historian's turf:

Bad job, by Tiago: Imagine I write a paper on Behavioral Macroeconomics making off the cuff observations about the latest financial products and how my bank manager frames that information, and noting my friends and neighbors’ flight to safety or to risk on the flimsiest of whims. Imagine I make no reference to secondary literature, or to methodology as I approach the questions.

Were I then to submit this piece to general appreciation, say get Robert Shiller to referee it. How do you think he would assess my effort?

I am sure we would be fast and dirty in telling me to do something else with my time.

I have not written a paper on Behavioral Macroeconomics and have no intention of doing so. But Shiller has written a working paper, kind of on the history of economics (Cowles Foundation Discussion Paper No. 1788 – Economists as Worldly Philosophers). There is no thread to the argument, no understanding of context, and zero references to the vast body of work by historians on his subject. The working paper, I am sure, will get plenty of readers, downloads and comments. But were I ever to referee it, I would be fast and dirty in telling him to do something else with his time.

Mankiw and Weinzierl: An Exploration of Optimal Stabilization Policy

I haven't had a chance to ready beyond the introduction and conclusion of this paper by Greg Mankiw and Matthew Weinzierl, "An Exploration of Optimal Stabilization Policy," but a couple of quick reactions. First, in the paper, in order for there to be a case for fiscal policy at all, the economy must be at the zero bound and the monetary authority must be "unable to commit itself to expansionary future policy." This point about commitment has been made in other papers (I believe Eggertsson, for example, notes this), and I think the credibility of future promises to create inflation is a problem. If so, if the Fed cannot credibly commit to future inflationary policy, then this paper provides a basis for, not against, fiscal policy when the economy is stuck at the zero bound.

Second, they note in the paper that tax policy can do a better job of replicating the flexible price equilibrium in terms of the allocation of resources, and hence tax policy should be used instead of government spending. However, since I think that there is a strong case that we are short on infrastructure, and that public goods problems prevent the private sector from providing optimal quantities of these goods on its own, I don't see the distributional issues as an important objection to government spending at present.

Here's the introduction to the paper:

An Exploration of Optimal Stabilization Policy, by N. Gregory Mankiw and Matthew Weinzierl March 8, 2011:  1 Introduction What is the optimal response of monetary and fiscal policy to an economy-wide decline in wealth and aggregate demand? This question has been at the forefront of many economists' minds over the past several years. In the aftermath of the 2008-2009 housing bust, financial crisis, and stock market decline, people were feeling poorer than they did a few years earlier and, as a result, were less eager to spend. The decline in the aggregate demand for goods and services led to the most severe recession in a generation or more.

The textbook answer to such a situation is for policymakers to use the tools of monetary and fiscal policy to prop up aggregate demand. And, indeed, during this recent episode, the Federal Reserve reduced the federal funds rate -- its primary policy instrument -- almost all the way to zero. With monetary policy having used up its ammunition of interest rate cuts, economists and policymakers increasingly looked elsewhere for a solution. In particular, they focused on fiscal policy and unconventional instruments of monetary policy.

To traditional Keynesians, the solution is startlingly simple: The government should increase its spending to make up for the shortfall in private spending. Indeed, this was a main motivation for the $800 billion stimulus package proposed by President Obama and passed by Congress in early 2009. The logic behind this policy should be familiar to anyone who has taken a macroeconomics principles course anytime over the past half century.

Yet many Americans (including quite a few congressional Republicans) are skeptical that increased government spending is the right policy response. They are motivated by some basic economic and political questions: If we as individual citizens are feeling poorer and cutting back on our spending, why should our elected representatives in effect reverse these private decisions by increasing spending and going into debt on our behalf? If the goal of government is to express the collective will of the citizenry, shouldn't it follow the lead of those it represents by tightening its own belt?

Traditional Keynesians have a standard answer to this line of thinking. According to the paradox of thrift, increased saving may be individually rational but collectively irrational. As individuals try to save more, they depress aggregate demand and thus national income. In the end, saving might not increase at all. Increased thrift might lead only to depressed economic activity, a malady that can be remedied by an increase in government purchases of goods and services.

The goal of this paper is to address this set of issues in light of modern macroeconomic theory. Unlike traditional Keynesian analysis of fiscal policy, modern macro theory begins with the preferences and constraints facing households and …firms and builds from there. This feature of modern theory is not a mere fetish for microeconomic foundations. Instead, it allows policy prescriptions to be founded on the basic principles of welfare economics. This feature seems particularly important for the case at hand, because the Keynesian recommendation is to have the government undo the actions that private citizens are taking on their own behalf. Figuring out whether such a policy can improve the well-being of those citizens is the key issue, a task that seems impossible to address without some reliable measure of welfare.

"The Internet and Local Wages: A Puzzle"

This is from a description of new research forthcoming in the American Economic Review, “The Internet and Local Wages: A Puzzle,” by Avi Goldfarb, Chris Forman and Shane Greenstein:

What has the Internet Done for the Economy?, Kellogg Insight: ...There is widespread optimism among media commentators and policy makers that the Internet erases geographic and socioeconomic boundaries. The Death of Distance and The World Is Flat, two books that espouse that rosy view, were bestsellers. But in the early days of the Internet, the income gap between the upper and middle classes actually began to grow. “We thought it was just a very natural question to ask: is the Internet responsible?” Greenstein says.

Misplaced Optimism
The researchers studied trends from 1995 to 2000 in several large sets of data, including the Quarterly Census of Employment and Wages—which gives county-level information on average weekly wages and employment—and the Harte Hanks Market Intelligence Computer Intelligence Technology Database, which holds survey information about how firms use the Internet. In total, the researchers included relevant data for nearly 87,000 private companies with more than 100 employees each. Based on their older work, they focused only on advanced Internet technologies.

Out of about 3,000 counties in the U.S., in only 163 did business adoption of Internet technologies correlate with wage and employment growth, the study found. All of these counties had populations above 150,000 and were in the top quarter of income and education levels before 1995. Between 1995 and 2000, they showed a 28 percent average increase in wages, compared with a 20 percent increase in other counties (Figure 1).

Figure 1. Advanced Internet investment and wage growth by county type.

Why did the Internet make such big waves in these few areas? Greenstein believes the reason was that these areas already had sophisticated companies and the communications infrastructure needed to seize on the Internet’s opportunities. But there are other possibilities. The impact could have been due to a well-known phenomenon called “biased technical change,” which means that new technologies can thrive only in places with skilled workers who know how to use them. Or it could have been because cities brought certain advantages—denser labor markets, better communication, tougher competition—than more remote areas.

“Each one of those explanations is plausible in our data, and probably explains a piece of it. But none of them by themselves can explain the whole story,” Greenstein says. “It’s really a puzzle.” ...

Inequality and the Distribution of Human Capital

Does skill-biased technological change explain inequality?:

The Wage Premium Puzzle and the Quality of Human Capital, by Milton H. Marquis, Bharat Trehany, and Wuttipan Tantivongz: Abstract The wage premium for high-skilled workers in the United States, measured as the ratio of the 90th-to-10th percentiles from the wage distribution, increased by 20 percent from the 1970s to the late 1980s. A large literature has emerged to explain this phenomenon. A leading explanation is that skill-biased technological change (SBTC) increased the demand for skilled labor relative to unskilled labor. In a calibrated vintage capital model with heterogenous labor, this paper examines whether SBTC is likely to have been a major factor in driving up the wage premium. Our results suggest that the contribution of SBTC is very small, accounting for about 1/20th of the observed increase. By contrast, a gradual and very modest shift in the distribution of human capital across workers can easily account for the large observed increase in wage inequality.

And what might explain the change in the distribution of human capital? From the conclusions:

factors that alter the skill distribution of the workforce appear to be a promising avenue of future research, since relatively small changes in the skill distribution can have large effects on the wage premia. Such factors could include immigration, population growth, or deficiencies in the educational system in failing to provide job-relevant training. At the high end of the skill distribution, endogenous increases in human capital may be taking place in locations such as Silicon valley.

"The Recent Evolution of the Natural Rate of Unemployment"

Research from Mary Daly, Bart Hobijn, and Rob Valletta of the SF Fed says that the increase in the structural rate of unemployment is relatively small, and it is expected to be transitory: (they estimate that only "about 0.5 percentage points or less" of the increase in unemployment is persistent):

Abstract The U.S. economy is recovering from the financial crisis and ensuing deep recession, but the unemployment rate has remained stubbornly high. Some have argued that the persistent elevation of unemployment relative to historical norms reflects the fact that the shocks that hit the economy were especially disruptive to labor markets and likely to have long lasting effects. If such structural factors are at work they would result in a higher underlying natural or nonaccelerating inflation rate of unemployment, implying that conventional monetary and fiscal policy should not be used in an attempt to return unemployment to its pre-recession levels. We investigate the hypothesis that the natural rate of unemployment has increased since the recession began, and if so, whether the underlying causes are transitory or persistent. We begin by reviewing a standard search and matching model of unemployment, which shows that two curves—the Beveridge curve (BC) and the Job Creation curve (JCC)—determine equilibrium unemployment. Using this framework, our joint theoretical and empirical exercise suggests that the natural rate of unemployment has in fact risen over the past several years, by an amount ranging from 0.6 to 1.9 percentage points. This increase implies a current natural rate in the range of 5.6 to 6.9 percent, with our preferred estimate at 6.25 percent. After examining evidence regarding the effects of labor market mismatch, extended unemployment benefits, and productivity growth, we conclude that only a small fraction of the recent increase in the natural rate is likely to persist beyond a five-year forecast horizon.

"Have We Underestimated the Likelihood and Severity of Zero Lower Bound Events?"

An interesting new paper from Hess Chung, Jean-Philippe Laforte, and David Reifschneider of the Board of Governors, and John Williams of the SF Fed:

Have We Underestimated the Likelihood and Severity of Zero Lower Bound Events?, by Hess Chung, Jean-Philippe Laforte, David Reifschneider, and John C. Williams, January 7, 2011: Abstract Before the recent recession, the consensus among researchers was that the zero lower bound (ZLB) probably would not pose a significant problem for monetary policy as long as a central bank aimed for an inflation rate of about 2 percent; some have even argued that an appreciably lower target inflation rate would pose no problems. This paper reexamines this consensus in the wake of the financial crisis, which has seen policy rates at their effective lower bound for more than two years in the United States and Japan and near zero in many other countries. We conduct our analysis using a set of structural and time series statistical models. We find that the decline in economic activity and interest rates in the United States has generally been well outside forecast confidence bands of many empirical macroeconomic models. In contrast, the decline in inflation has been less surprising. We identify a number of factors that help to account for the degree to which models were surprised by recent events. First, uncertainty about model parameters and latent variables, which were typically ignored in past research, significantly increases the probability of hitting the ZLB. Second, models that are based primarily on the Great Moderation period severely understate the incidence and severity of ZLB events. Third, the propagation mechanisms and shocks embedded in standard DSGE models appear to be insufficient to generate sustained periods of policy being stuck at the ZLB, such as we now observe. We conclude that past estimates of the incidence and effects of the ZLB were too low and suggest a need for a general reexamination of the empirical adequacy of standard models. In addition to this statistical analysis, we show that the ZLB probably had a first-order impact on macroeconomic outcomes in the United States. Finally, we analyze the use of asset purchases as an alternative monetary policy tool when short-term interest rates are constrained by the ZLB, and find that the Federal Reserve’s asset purchases have been effective at mitigating the economic costs of the ZLB. In particular, model simulations indicate that the past and projected expansion of the Federal Reserve's securities holdings since late 2008 will lower the unemployment rate, relative to what it would have been absent the purchases, by 1½ percentage points by 2012. In addition, we find that the asset purchases have probably prevented the U.S. economy from falling into deflation.

And, from the conclusions:

Sumner's Reply on Nominal GDP Targeting

Here's a response to my request for more discussion of the merits of nominal GDP targeting (in both levels and growth rates) relative to a Taylor rule:

Reply to Thoma on NGDP targeting, by Scott Sumner: Mark Thoma recently asked the following question:

So, for those of you who are advocates of nominal GDP targeting and have studied nominal GDP targeting in depth, (a) what important results concerning nominal GDP targeting have I left out or gotten wrong? (b) Why should I prefer one rule over the other? In particular, for proponents of nominal GDP targeting, what are the main arguments for this approach? Why is targeting nominal GDP better than a Taylor rule?

...Thoma raises issues that I don’t feel qualified to discuss, such as learnability.  My intuition says that’s not a big problem, but no one should take my intuition seriously.  What people should take seriously is Bennett McCallum’s intuition (in my view the best in the business), and he also thinks it’s an overrated problem.  I think the main advantage of NGDP targeting over the Taylor rule is simplicity, which makes it more politically appealing.  I’m not sure Congress would go along with a complicated formula for monetary policy that looks like it was dreamed up by academics (i.e. the Taylor Rule.)  In practice, the two targets would be close, as Thoma suggested elsewhere in the post.

Instead I’d like to focus on a passage that Thoma links to, which was written by Bernanke and Mishkin in 1997 ...[continue reading]...

Just one quick note. I'm not sure I agree that McCallum thinks learnability is an "overrated problem." For example, he cites it as an important factor in arguing against using determinacy as a "selection criterion for rational expectations models":

Another Weakness of “Determinacy” as a Selection Criterion for Rational Expectations Models, by Seonghoon Cho and Bennett T. McCallum: ...It is well-known that dynamic linear rational expectations (RE) models often have multiple solutions... It is also well-known that much of the literature, especially in monetary economics, approaches issues concerning such multiplicities by establishing whether a solution is, or is not, “determinate” in the sense of being the only solution that is dynamically stable. Often, cases featuring “indeterminacy,” defined as the existence of more than one stable solution, are regarded as problematic and to be avoided (by means of policy) if possible.[1] On the other hand, several authors, including Bullard (2006), Cho and Moreno (2008), Evans and Honkapohja (2001), and McCallum (2003, 2007) have— implicitly, in some cases—questioned this practice on various grounds. For example, determinate solutions may not be learnable (Bullard (2006), Bullard and Mitra (2002)) whereas cases with indeterminacy may possess only one “plausible” solution (McCallum (2003, 2007)). In the present paper we present another argument against the use of determinacy as a guide ... to interpretation of outcomes implied by a RE model.

Or, probably better, see his rejoinder to Cochrane's "Can Learnability save New-Keynesian models?," one of many papers he has written on this topic, and see if you conclude that McCallum thinks learnability is an unimportant issue.

"Sunshine: at the IMF, of all Places"

A new paper argues that the best solution to a financial crisis like the one we just experienced is to increase the share of income going to labor:

Sunshine: at the IMF, of all places, by Alex Harrowell, A Fist Full of Euros: So, here we are, after a 2010 of economic horrors. There is extensive debate as to whether the standard tools of economics are even valid... But is anyone at least trying to do something original with the standard toolkit? The DSGE model may be one of John Quiggin’s zombies..., but zombies are notoriously resilient. ...

The answer on this occasion is yes, at least as far as Michael Kumhof and Romain Ranciére, go. In a new paper, they present a DSGE model... Then, they run a simulation of the macro-economy assuming that there is a negative shock to the bargaining power of labor resulting in a shift in the income distribution.

The simulation results were that the financial sector balloons in size, that total private debt in the economy expands hugely, and that credit acts as a substitute for rising average wages in the short run. Eventually, the model produced a massive financial crisis and a brutal recession, followed by a blow-out of the government budget.

Your keen and agile minds will not have missed that flat real wages, an increased share of national income going to the top 5%, enormous growth in the financial sector, and a credit-financed consumer boom are exactly what happened to the macroeconomy in the last 30 years. ...

So, what should we do about it? Kumhof and Ranciére have something to say about that as well. ... They considered a scenario in which the government took the pain, accepting a large government deficit in order to minimize the impact of the crisis on the real economy. This had the advantage of reducing the fall in GDP, and therefore allowing growth to reduce households’ leverage. They also considered the option of just suffering, which actually increased leverage as incomes fell and the stock of debt remained.

Then they considered two more positive responses to the crisis. One was a debt restructuring, or to be brutal about it, widespread default and bankruptcy. This had the advantage that it does, indeed, reduce the leverage burden and does so cheaply. It also implies the end of the big banks...

The other was to increase labor's share of income. They found that this achieved a faster, bigger, and more lasting reduction in leverage and a reduced probability of crises. In their own words:

...For long-run sustainability a permanent flow adjustment, giving workers the means to repay their obligations over time, is therefore much more successful... But without the prospect of a recovery in the incomes of poor and middle income households over a reasonable time horizon, the inevitable result is that loans keep growing, and therefore so does leverage and the probability of a major crisis that, in the real world, typically also has severe implications for the real economy.

They also argue that the inequality-finance-lending transmission mechanism might also explain the global imbalances... However, they haven’t extended the model to include the international dimension yet, although it’s on their agenda for further research.

I’ve waited for this moment, 752 words on, to mention the key detail: this cell of dangerous subversive Bolsheviks is embedded in the International Monetary Fund, and their poisonous hate-writings were published as an IMF Working Paper. Perhaps DSK really has had an influence on the institution? ...

"Effects of the Financial Crisis and Great Recession on American Households"

The conclusion to this paper by Michael Hurd and Susann Rohwedder is not very encouraging:

Effects of the Financial Crisis and Great Recession on American Households, by Michael D. Hurd and Susann Rohwedder, NBER [open link]: Introduction ...In this paper we present results about the effects of the economic crisis and recession on American households. They come from high-frequency surveys dedicated to tracking the effects of the crisis and recession that we conducted in the American Life Panel – an Internet survey run by RAND Labor and Population. The first survey was fielded at the beginning of November 2008, immediately following the large declines in the stock market of September and October. The next survey followed three months later in February 2009. Since May 2009 we have collected monthly data on the same households. ...

Conclusions The economic problems leading to the recession began with a housing price bubble in many parts of the country and a coincident stock market bubble. These problems evolved into the financial crisis. ...

According to our measures almost 40% of households have been affected either by unemployment, negative home equity, arrears on their mortgage payments, or foreclosure. Additionally economic preparation for retirement, which is hard to measure, has undoubtedly been affected. Many people approaching retirement suffered substantial losses in their retirement accounts: indeed in the November 2008 survey, 25% of respondents aged 50-59 reported they had lost more than 35% of their retirement savings, and some of them locked in their losses prior to the partial recovery in the stock market by selling out. Some persons retired unexpectedly early because of unemployment, leading to a reduction of economic resources in retirement which will be felt throughout their retirement years. Some younger workers who have suffered unemployment will not reach their expected level of lifetime earnings and will have reduced resources in retirement as well as during their working years.

Spending has been approximately constant since it reached its minimum in about November, 2009. Short-run expectations of stock market gains and housing prices gains have recovered somewhat, yet are still rather pessimistic; and, possibly more telling, longer-term expectations for those price increases have declined substantially and have shown no signs of recovery. The implication is that long-run expectations have become pessimistic relative to short-run expectations.

Expectations about unemployment have improved somewhat from their low point in May 2009 but they remain high: they predict that about 18% of workers will experience unemployment over a 12 month period. Despite the public discussion of the necessity to work longer, expectations about working to age 62 among those not currently working declined by 10 percentage points. In our view this decline reflects long-term pessimism about the likelihood of a successful job search.

The recession officially ended in June 2009. A main component of that judgment is that the economy is no longer declining. According to our data the economic situation of the typical household is no longer worsening which is consistent with the end of the recession defined as negative change. However, when defined in terms of levels rather than rates of change, from the point of view of the typical household the Great Recession is not over.

The Stagnation Regime of the New Keynesian Model and Current US Policy

My colleague George Evans has an interesting new paper. He shows that when there is downward wage rigidity, the "asymmetric adjustment costs" referenced below, the economy can get stuck in a zone of stagnation. Escaping from the stagnation trap requires a change in government spending or some other shock of sufficient size. If the change in government spending is large enough, the economy will return to full employment. But if the shock to government spending is below the required threshold (as the stimulus package may very well have been), the economy will remain trapped in the stagnation regime.

(I also highly recommend section 4 on policy implications, which I have included on the continuation page. It discusses fiscal policy options, quantitiative easing, how to help to state and local governments, and other policies that could help to get us out of the stagnation regime):

The Stagnation Regime of the New Keynesian Model and Current US Policy, by George Evans: 1 Introduction The economic experiences of 2008-10 have highlighted the issue of appropriate macroeconomic policy in deep recessions. A particular concern is what macroeconomic policies should be used when slow growth and high unemployment persist even after the monetary policy interest rate instrument has been at or close to the zero net interest rate lower bound for a sustained period of time. In Evans, Guse, and Honkapohja (2008) and Evans and Honkapohja (2010), using a New Keynesian model with learning, we argued that if the economy is subject to a large negative expectational shock, such as plausibly arose in response to the financial crisis of 2008-9, then it may be necessary, in order to return the economy to the targeted steady state, to supplement monetary policy with fiscal policy, in particular with temporary increases in government spending.

The importance of expectations in generating a “liquidity trap” at the zero-lower bound is now widely understood. For example, Benhabib, Schmitt-Grohe, and Uribe (2001b), Benhabib, Schmitt-Grohe, and Uribe (2001a) show the possibility of multiple equilibria under perfect foresight, with a continuum of paths to an unintended low or negative inflation steady state.[1] Recently, Bullard (2010) has argued that data from Japan and the US over 2002-2010 suggest that we should take seriously the possibility that “the US economy may become enmeshed in a Japanese-style deflationary outcome within the next several years.”

The learning approach provides a perspective on this issue that is quite different from the rational expectations results.[2] As shown in Evans, Guse, and Honkapohja (2008) and Evans and Honkapohja (2010), when expectations are formed using adaptive learning, the targeted steady state is locally stable under standard policy, but it is not globally stable. However, the potential problem is not convergence to the deflation steady state, but instead unstable trajectories. The danger is that sufficiently pessimistic expectations of future inflation, output and consumption can become self-reinforcing, leading to a deflationary process accompanied by declining inflation and output. These unstable paths arise when expectations are pessimistic enough to fall into what we call the “deflation trap.” Thus, while in Bullard (2010) the local stability results of the learning approach to expectations is characterized as one of the forms of denial of “the peril,” the learning perspective is actually more alarmist in that it takes seriously these divergent paths.

As we showed in Evans, Guse, and Honkapohja (2008), in this deflation trap region aggressive monetary policy, i.e. immediate reductions on interest rates to close to zero, will in some cases avoid the deflationary spiral and return the economy to the intended steady state. However, if the pessimistic expectation shock is too large then temporary increases in government spending may be needed. The policy response in the US, UK and Europe has to some extent followed the policies advocated in Evans, Guse, and Honkapohja (2008). Monetary policy has been quick, decisive and aggressive, with, for example, the US federal funds rate reduced to near zero levels by the end of 2008. In the US, in addition to a variety of less conventional interventions in the financial markets by the Treasury and the Federal Reserve, including the TARP measures in late 2008 and a large scale expansion of the Fed balance sheet designed to stabilize the banking system, there was the $727 billion ARRA stimulus package passed in February 2009.

While the US economy has stabilized, the recovery has to date been weak and the unemployment rate has been both very high and roughly constant for about one year. At the same time, although inflation is low, and hovering on the brink of deflation, we have not seen the economy recording large and increasing deflation rates.[3] From the viewpoint of Evans, Guse, and Honkapohja (2008), various interpretations of the data are possible, depending on one’s view of the severity of the initial negative expectations shock and the strength of the monetary and fiscal policy impacts. However, since recent US (and Japanese) data may also consistent with convergence to a deflation steady state, it is worth revisiting the issue of whether this outcome can in some circumstances arise under learning.

In this paper I develop a modification of the model of Evans, Guse, and Honkapohja (2008) that generates a new outcome under adaptive learning. Introducing asymmetric adjustment costs into the Rotemberg model of price setting leads to the possibility of convergence to a stagnation regime following a large pessimistic shock. In the stagnation regime, inflation is trapped at a low steady deflation level, consistent with zero net interest rates, and there is a continuum of consumption and output levels that may emerge. Thus, once again, the learning approach raises the alarm concerning the evolution of the economy when faced with a large shock, since the outcome may be persistently inefficiently low levels of output. This is in contrast to the rational expectations approach of Benhabib, Schmitt-Grohe, and Uribe (2001b), in which the deflation steady state has output levels that are not greatly different from the targeted steady state.

In the stagnation regime, fiscal policy, taking the form of temporary increases in government spending, is important as a policy tool. Increased government spending raises output, but leaves the economy within the stagnation regime until raised to the point at which a critical level of output is reached. Once output exceeds the critical level, the usual stabilizing mechanisms of the economy resume, pushing consumption, output and inflation back to the targeted steady state, and permitting a scaling back of government expenditure.

Here is the section on policy options recommended above (it is relatively non-technical):

Does a Higher Minimum Wage Reduce Jobs?

Arin Dube is interviewed about his research on the effects of the minimum wage (link to academic paper):

Here's a description of the interview:

Does Higher Minimum Wage Reduce Jobs?: ...In an interview with The Real News, Arindrajit Dube, labor economist and Assistant Professor of Economics at University of Massachusetts, said that increasing the minimum wage in some areas has not reduced jobs as expected by the conventional theory. 

Dube’s research looks at the effects of minimum wage differentials across state borders where the minimum wage is higher on one side of the border than the other. His research looks at the service industry, which he said employs the majority of minimum wage workers. According to his findings, both the short and long term effects of the increased wage on unemployment were negligible. 

“And that, I think, is an important factor to keep in mind for policymakers as they consider raising the minimum wage,” he said.

Dube said the conventional wisdom surrounding minimum wage comes from research done before the early ‘90s. ... Dube told TRNN that around the early to mid ‘90s some economists realized these studies were badly flawed, and began looking at local evidence instead of just national evidence. The famous work of labor economists David Card and Alan Kruger looked at the border of New Jersey and Pennsylvania when New Jersey raised its minimum wage. Within a year, he said, not only had employment in New Jersey not decreased, it had actually risen in some groups. 

He said the report received strong criticism from the economic community, but Dube’s studies apply this technique across borders of all the states, over a twenty year period to track the effects in many cases, and for a much longer period. 

“In that sense, we build on, but really generalize the Card and Kruger approach, and really address some of the serious criticisms that were made. And at the end of the day our results are actually strikingly similar to the original Card and Kruger finding, even though we were able to respond to pretty much all the criticisms that were levied against the single, case study approach.” 

Dube’s findings indicate that a higher minimum wage helps service retailers attract and retain employees, increasing their productivity. He said that a restaurateur, for example, is likely to reduce his employees when the wage goes up if only one restaurant raises their wage, but if most of them raise it, the added cost is passed on to the consumer who is likely to absorb it without decreasing their demand. 

Dube’s findings are specific to the service industry, which is generally tied to a specific market and does not have the mobility that manufacturing jobs have. However, he said there are very few Americans left in manufacturing that receive the minimum wage. ...

He said the ‘spillover effect’, where rising the minimum wage pushes up other wages, has only been found to affect those earning up to 25 per cent more than the minimum wage. 

Finally he added that work done by economists at the Federal Reserve showed minimum wage increase led to significant increases in purchases of durable goods. “From a perspective of stimulating demand, minimum wages will tend to increase demand by increasing the purchasing power of those workers.”

Will a Payroll Tax Cut Stimulate the Economy?

Will a payroll tax cut stimulate the economy? I am going to answer this in the context of  Gauti B. Eggertsson' paper "What Fiscal Policy Is Effective at Zero Interest Rates?" where this question is addressed directly (the analysis begins on page 13). The model is New Keynesian.

The answer, in this model anyway, is that in normal times a payroll tax cut would be stimulative, but at the zero bound it's not so clear. Let me see if I can explain why.

When interest rates are positive, the framework is essentially a standard AS-AD model:

A payroll tax cut increases labor supply and shifts out the AS curve. The shift in the AS curve results in lower inflation and higher output/employment.

One thing that is left out of this model to simplify the analysis and keep it tractable is the demand-side effects of such policies. That is, a tax cut would also increase AD. If we add this effect, the graph then looks like:

Output goes up even more, but whether inflation goes up or down depends upon which shift is larger, the shift in the AS or the shift in the AD (based upon the evidence on how labor supply responds to changes in taxes, I would expect that the shift in the AD would be larger and come first, but ultimately that is an empirical matter).

When the economy is at the zero bound for the nominal interest rates things change. In particular, the AD curve slopes upward. This will be explained intuitively in a moment, but mechanically the effect of a positively sloped AD curve is as follows:

Thus, when we consider only the supply-side effects of a tax cut, it has a negative impact on output and employment. Why is this?

Figure 5 clarifies the intuition for why labor tax cuts become contractionary at zero interest rates while being expansionary under normal circumstances. The key is aggregate demand. At positive interest rates the AD curve is downward-sloping in inflation. The reason is that as inflation decreases, the central bank will cut the nominal interest rate more than 1 to 1 with inflation..., which is the Taylor principle... Similarly, if inflation increases, the central bank will increase the nominal interest rate more than 1 to 1 with inflation, thus causing an output contraction with higher inflation. As a consequence, the real interest rate will decrease with deflationary pressures and expanding output, because any reduction in inflation will be met by a more than proportional change in the nominal interest rate. This, however, is no longer the case at zero interest rates, because interest rates can no longer be cut. This means that the central bank will no longer be able to offset deflationary pressures with aggressive interest rate cuts, shifting the AD curve from downward-sloping to upward-sloping in (YL,πL) space...

The reason is that lower inflation will now mean a higher real rate, because the reduction in inflation can no longer be offset by interest rate cuts. Similarly, an increase in inflation is now expansionary because the increase in inflation will no longer be offset by an increase in the nominal interest rate; hence, higher inflation implies lower real interest rates and thus higher demand.

Once again, however, demand side effects are missing. Tacking those on gives:

Thus, the overall effect on employment depends upon the net effect of the AD and AS shifts. If the AD shift dominates, as I suspect it would, this policy will still have positive effects on output and employment. But the size of the effect depends upon the strength of the demand side shift, and how strong the shift would be is an open question, particularly given the degree of household balance sheet rebuilding we are seeing which causes the tax cuts to be saved rather than spent. [The timing matters as well with the AD effects generally coming first, so in the SR the demand side effects should dominate. If so, that is a reason to be a bit more supportive of these policies.]

Another way to think about this is the following. Supply is not the problem right now, it's lack of demand, and a policy that encourages more supply and threatens deflation is not helpful except to the extent that it increases aggregate demand in the process. Other types of policies can avoid this problem, see, for example the sales tax cut discussed on page 20 or the discussion of fiscal policy multipliers on page 17, but they may not have the same political feasibility as  tax cut for labor, which itself doesn't seem all that likely give the degree of opposition it will likely hit in Congress (the sales tax cut would be difficult to implement given that sales taxes are levied at the state level, and there's no chance that government spending increases will pass Congress right now; on the politics of a payroll tax cut, see the end of this post).

*****

[Note: The demand-side effects were left out of the paper to keep the mathematics tractable, and it may be that simply tacking on the demand-side effects as I've done (the red lines) isn't quite correct. I think it's okay, but if anyone can speak to this, that would be great. Also, the policy analyzed in the paper is best interpreted as a payroll tax cut on the worker side. I don't think it matters if the cut is on the employer side, and I hope the administration doesn't pursue this anyway since the employer side tax cut may not pass through to labor fully, or much at all in the very short-run, but, again, if that matters and someone can speak to this point, please do.]

The "Obama Shock" Hypothesis "Seems Ridiculous"

What has happened to Ed Prescott?:

Stephen Williamson: ...Ed Prescott did pathbreaking work in the economics profession, and his Nobel prize is well-deserved. His work with Finn Kydland made macroeonomists more quantitatively disciplined, and serves as a benchmark for most of the work done in macro in the last 30 years, including New Keynesian economics, models with financial frictions, and incomplete markets models. However, I doubt that there were any people in the room yesterday who took Ed seriously. Ed's key points were: 1. Monetary policy does not matter. 2. Financial factors are the symptoms, not the causes, of the recent downturn. 3. The recession was due to an Obama shock, i.e. labor supply fell because US workers anticipate higher future taxes. Bob Hall suggested that this would require a Frisch labor supply elasticity of about 27, which seems ridiculous. However, Ed stuck to his guns and thus seemed - well, ridiculous. As a basic framework, the real business cycle model is obviously useful - you can't argue with a basic framework of preferences, endowments, technology, and optimal choice. I think we know by now, though, that financial factors have a lot to do with what we are measuring as TFP (total factor productivity). We certainly should not be listening to suggestions that central banks are irrelevant - these institutions can clearly reallocate resources in a big way when they want to.

Prescott isn't alone in pushing the "Obama shock" idea. The claim is that the recession is due to a labor supply shock where workers collective decide to work less due to one government program or another, or some type of technology shock. So good to see there's some pushback against the silly claims being made by adherents to the RBC model.

But there are also those who think the New Keynesian model is, well, silly. On this topic, see David Andolfato's criticism of the New Keynesian model and Nick Rowe's response.

One of the points David Andolfatto raises is the evidence for the sticky price assumption, but the discussion of the evidence for and against the sticky price assumption is a bit slim. I haven't had time to write up a response to David and Nick due to deadline pressure, but let me try to add to the discussion by repeating a summary of some of the evidence from a post from 2007 (this is also very far from an exhaustive accounting of the work on this issue, but hopefully it's representative):

...[This is] from a paper I read not too long ago. According to this work, the degree of rigidity in prices depends upon the level of aggregation examined, the degree of monopoly power, and the type of shock hitting firms:

Sticky Prices and Monetary Policy: Evidence from Disaggregated U.S. Data, by Jean Boivin, Marc Giannoni, Ilian Mihov , NBER WP 12824, January 2007 [open link]  Abstract This paper disentangles fluctuations in disaggregated prices due to macroeconomic and sectoral conditions using a factor-augmented vector autoregression estimated on a large data set. On the basis of this estimation, we establish eight facts: (1) Macroeconomic shocks explain only about 15% of sectoral inflation fluctuations; (2) The persistence of sectoral inflation is driven by macroeconomic factors; (3) While disaggregated prices respond quickly to sector-specific shocks, their responses to aggregate shocks are small on impact and larger thereafter; (4) Most prices respond with a significant delay to identified monetary policy shocks, and show little evidence of a "price puzzle," contrary to existing studies based on traditional VARs; (5) Categories in which consumer prices fall the most following a monetary policy shock tend to be those in which quantities consumed fall the least; (6) The observed dispersion in the reaction of producer prices is relatively well explained by the degree of market power; (7) Prices in sectors with volatile idiosyncratic shocks react rapidly to aggregate monetary policy shocks; (8) The sector-specific components of prices and quantities move in opposite directions.

The main contribution of the paper is to divide shocks into two types, economy-wide shocks that hit all sectors, and sector specific shocks that hit individual sectors, and to do so in an econometrically defensible manner.

In previous results, when shocks were not disentangled to separate economy-wide and sector specific shocks, empirical results tended to find a large degree of price stickiness at both the aggregate and sectoral levels lending support to sluggish-price, menu-cost* type models.

This paper follows in the path of previous work showing that individual prices, or at least highly disaggregated prices, are far more volatile, i.e. flexible, than typically assumed in sluggish price models.

Restating the results, when the authors separate shocks into aggregate and sector specific shocks, they find that:

1. Most of the price volatility at the sectoral level is due to sectoral shocks, not aggregate shocks.

2. Differences in price-setting behavior across sectors are mostly due to differences in the response to sector-specific shocks, most sectors respond similarly to aggregate shocks.

3. There is persistence (stickiness) in the response of disaggregated prices, but this is due to the response to aggregate shocks. There is little persistence in the response of disaggregated prices to sector specific shocks. In addition, the response of disaggregated prices to sector specific shocks is more immediate than the response to aggregate shocks.

4. The differences in the responses across sectors is explained by differences in market power. More monopoly power implies more stickiness.

5. There is no longer a price puzzle (the annoying tendency for prices to rise after the Fed tightens in empirical models used for policy analysis).

Overall, then, what this paper finds is that firms exhibit considerable flexibility in responding to sector specific shocks - there is not much price stickiness on display - but a much more sluggish response to aggregate shocks.

One thing that is needed is to explain these results theoretically. The paper outlines some recent attempts in this direction, but there is much more work needed on both the empirical evidence about price stickiness and on the supporting theoretical models.

The sluggish price to aggregate shocks is still present, so this doesn't rule out aggregate fluctuations driven by aggregate shocks. That is, I don't think the evidence against the sticky price hypothesis is quite as strong as David implies (though he is very careful to note that there is evidence for the assumption). That is from:

• Sticky Prices: Differences in the Behavior of Aggregated and Disaggregated Prices (on Sticky Prices and Monetary Policy: Evidence from Disaggregated U.S. Data, by Jean Boivin, Marc Giannoni, and Ilian Mihov, January 2007: the Boivin, Giannoni, and Mihov 2007 paper)

See also

• Sticky Prices and Monetary Policy (also on Sticky Prices and Monetary Policy: Evidence from Disaggregated U.S. Data, by Jean Boivin, Marc Giannoni, and Ilian Mihov, January 2007: the Boivin, Giannoni, and Mihov 2007 paper)
• Price Rigidity (on  "Reference Prices and Nominal Rigidities," by Martin Eichenbaum, Nir Jaimovich, and Sergio Rebelo, March 2008
• Are Prices Sticky? (summary of research)
• Golosov and Lucas: Menu Costs and Phillips Curves (on Menu Costs and Phillips Curves, by Mikhail Golosov and Robert E. Lucas Jr., Journal of Political Economy, 2007, vol. 115, no. 2
  [open link]
• More (Google search for related posts on this site)

Finally, this is a different topic, but since the wonkiness door is open, Paul Krugman posted a discussion of monetary policy earlier today:

• How Much Can The Fed Help? (Wonkish)

I discuss Krugman's here, in particular why we shouldn't place too much faith in the Fed's ability to stimulate the economy through further reductions in long-term interest rates.

Update: Paul krugman comments on Prescott and RBC models.

Woodford: Financial Intermediation and Macroeconomic Analysis

While I'm on the topic of modern macro models, here's a recent paper (May 2010) from Michael Woodford that I came across while running down a reference for the post that follows this on. One of the missing elements in modern models -- a point I've made here often -- is the connection between financial intermediation and the real economy. So it's nice to see Woodford pushing in this direction:

Financial Intermediation and Macroeconomic Analysis, by Michael Woodford, May 2010: How will the financial crisis change the teaching of macroeconomics? While it is difficult to predict intellectual developments before they occur, one can be reasonably confident that the macroeconomic implications of developments in the financial sector will receive a great deal more attention from now on. Of course, issues relating to financial stability have always been part of the curriculum --- though perhaps presented as mainly of historical interest, or primarily of relevance to emerging markets. But recent events have made it clear that financial issues need to be integrated much more thoroughly into the basic framework for macroeconomic analysis with which students are provided.

Why has financial intermediation not played a more central role in the macroeconomic theory of the past few decades? Some suggest that fundamental theoretical or methodological commitments have made it difficult for mainstream macroeconomists to consider hypotheses under which financial conditions can be considered an independent determinant of economic outcomes. But a more straightforward explanation is that financial developments, at least in the U.S., had rendered the kinds of financial constraints previously emphasized in macroeconomic analysis less obviously important.

The Keynesian macroeconomic models of the third quarter of the twentieth century had emphasized the determinants of expenditure flows as the crucial factors behind variations in both economic activity and inflation, and the availability of credit was certainly recognized as among the important determinants of at least some key categories of spending. But the constraints on the availability of credit that were emphasized in models of the time resulted from specific institutional forms and regulatory requirements that came to be of less relevance.

For example, accounts of the “bank lending channel” of the transmission of monetary policy emphasized the indispensable role of traditional commercial banks as sources of credit for certain kinds of borrowers, without direct access to capital markets.¹ Deposits were in turn held to be an indispensable source of funding for the lending of commercial banks, and these were subject to legal reserve requirements. To the extent that the latter requirements were typically a binding constraint, a reduction in the supply of reserves by the Fed would require the volume of deposits to be reduced, which would in turn require less lending by commercial banks. Yet the importance of this channel for effects of monetary policy on economic activity depended on the simultaneous validity of each of the links in the proposed mechanism: the reserve requirements a binding constraint for many banks, the lack of sources of funding for commercial banks other than deposits, the lack of sources of credit other than commercial banks for an important subset of borrowers, and the lack of opportunities for banks to substitute between other assets and the kind of lending for which they were essential.

Each of these assumptions was less obviously defensible after the financial innovations and regulatory changes of the 1980s and 1990s.² Non-bank financial intermediaries became increasingly important as sources of credit, particularly as a result of the growing popularity of securitization. Panel (a) of Figure 1 [here] shows total net lending by the U.S. private financial sector; while commercial banks are clearly still important, they are far from the only important source of credit. More importantly, both the recent lending boom and the more recent financial crisis had more to do with changes in financial flows of several of the other types shown in the figure; for example, lending by ABS issuers surged in the period up until the summer of 2007, and then crashed.

And commercial banks themselves have increasingly turned to sources of funding other than deposits. Panel (b) of Figure 1 [here] shows the net increase in commercial-bank liabilities each quarter from each of several sources. Checkable deposits are only a small part of these institutions’ financing; moreover, deposits shrank during the years of the lending boom, but have risen again during the crisis --- so that neither the growth in commercial-bank assets during the boom nor the contraction of bank assets in 2009 can be attributed to variations in the availability of deposits as a source of financing.

And finally, with the increase in vault cash holdings that has resulted from the spread of ATM machines, reserve requirements have become no longer a binding constraint for many banks (even before the massive increase in the supply of bank reserves during the financial crisis).³ As a consequence, the continuing relevance of the traditional bank lending channel is subject to considerable doubt.

Such developments have made it tempting to abstract from credit frictions in macroeconomic modeling, at least as a first approximation.⁴ However, the recent financial crisis has made it plain that even in economies like the U.S., with substantially market-based financial systems, significant disruptions of financial intermediation remain a possibility. Understanding such phenomena, and analysis of possible policy responses to them, requires the development of a macroeconomic framework appropriate to a market-based financial system in which credit is nonetheless not a veil.

Fortunately, work on the development of more modern approaches to the introduction of credit frictions into macroeconomic analysis is well underway.⁵ Here I sketch the basic elements of a modern model, at a level of detail intended to be suitable for presentation in an undergraduate course.⁶ I begin by explaining the basic analytical framework, and then briefly discuss some of the implications of a model of this kind for monetary policy. ...[continue reading]...

Let me relate this to the post below this one, and adopt a more critical stance toward the existing work on policy multipliers during recessions such as the one we are experiencing. First, on the empirical side, there's the problem of not having very much data to work with. In New Keynesian models, the economy behaves very differently at the zero bound, so data from ordinary times doesn't tell us much. Thus, any estimates of the multipliers that are based upon data from times when the interest rate was above zero, which is most of the evidence that we have, are highly suspect.

Second, and more to the point of this post, with respect to the theoretical models, if we don't have the connections between the financial and real sectors fully modeled -- if important elements of the transmission mechanism for financial and policy shocks are missing -- then I don't know how much faith we can put in the multipliers (or monetary and fiscal policy) that we derive from these models. That's one reason why this new work is important. We don't know for sure that the policy prescriptions that are called for in the existing models will carry over to models that incorporate an explicit role for financial intermediation in supporting real activity. I think the outcome will be much the same in terms of the overall message about stimulating aggregate demand, and that the new models will justify many of the creative steps the Fed took during the crisis. But we can't be sure until we actually build these models and look at the types of polices that work the best within the new framework.

The Credibility of Monetary and Fiscal Policy

Scott Sumner, responding to a post by Tyler Cowen, says:

Expectations traps: They’re even more applicable to fiscal policy, by Scott Sumner: Tyler Cowen links to this post from Mark Thoma:

As for Tyler’s (and others’) call for monetary policy instead of fiscal policy, here’s the problem. It relies upon changing expectations of future inflation (which changes the real interest rate). You have to get people to believe that the Fed will actually be willing to create inflation in the future when it comes time to do so. However, it’s unlikely that it will be optimal for the Fed to cause inflation when the time comes. Because of that, the best policy is to promise that you’ll create inflation, then renege on the promise when it comes time to follow through. Since people know that, and expect the Fed will not actually carry through, it’s hard to get them to change their expectations now. All that credibility the Fed has built up and protected concerning their inflation fighting credentials works against them here.

Paul Krugman developed the idea of an expectations trap as a way of explaining the dilemma faced by the Bank of Japan.  Except there is just one problem.  Almost everyone agrees that Japan does not face an expectations trap.  They can devalue the yen whenever they wish, as much as they wish. ...

But here’s the bigger flaw with the whole expectations trap argument.  People think it applies to monetary policy, but they forget it applies equally to fiscal policy.  (Indeed I never realized this until today.)  Here’s why.  Krugman’s model relies on rational expectations, indeed you can’t get the expectations trap without ratex.  But if you have ratex in your model, then no policy can work unless it is expected to work.  ...

This is relatively easy to dispense with. First, those of us who pushed for fiscal policy were told we were basing this on old-fashioned models, IS-LM at best, maybe even more outdated than that. So the New Keynesian theorists went to work and showed that within the modern models used for policy analysis, fiscal policy does, in fact, find support.

The model I've been using in particular is Eggertsson's and to some extent Woodford's. The difference is that Eggertsson looks at how multipliers vary across various tax and government spending policies, while Woodford is more concerned with the determinants of the size of the government spending multiplier. For example, Woodford says:

Much public discussion of this issue has been based on old-fashioned models (both Keynesian and anti-Keynesian) that take little account of the role of intertemporal optimization and expectations in the determination of aggregate economic activity. Yet discussions of monetary stabilization policy over the past several decades have been transformed by the development of a new generation of macroeconomic models that simultaneously consider the dynamic implications of intertemporal optimization on the one hand, and delays in the adjustment of wages and prices on the other. The implications of these models for fiscal stabilization policy have been much less fully developed than their implications for monetary policy. But this is not because the models do not have implications for fiscal policy. The present paper reviews some of these implications for one specific question of current interest: the determinants of the size of the effect on aggregate output of an increase in government purchases, or what has been known since Keynes (1936) as the government expenditure "multiplier."

Going back to the creditability issue raised by Scott Sumner, one of the points that Eggertsson makes is that government spending does not have the credibility problem that plagues monetary policy. He says:

As shown by several authors, such as Eggertsson and Woodford (2003) and Auerbach and Obstfeld (2005), it is only the expectation about future money supply (once the zero bound is no longer binding) that matters ... when the interest rate is zero. ... Expansionary monetary policy can be difficult if the central bank cannot commit to future policy. The problem is that an inflation promise is not credible for a discretionary policy maker. ...

This credibility problem is what Eggertsson (2006) calls the "deflation bias" of discretionary monetary policy at zero interest rates. Government spending does not have this problem. ... The intuition is that fiscal policy not only requires promises about what the government will do in the future, but also involves direct actions today. And those actions are fully consistent with those the government promises in the future (namely, increasing government spending throughout the recession period). ...

Even so, monetary policy might still work, it's a matter of being able to credibly commit to future inflation:

It seems quite likely that, in practice, a central bank with a high degree of credibility, can make credible announcements about its future policy and thereby have considerable effect on expectations. Moreover, many authors have analyzed explicit steps, such as expanding the central bank balance sheet through purchases of various assets such as foreign exchange, mortgage-backed securities, or equities, that can help make an inflationary pledge more credible (see, e.g., Eggertsson (2006), who shows this in the context of an optimizing government, and Jeanne and Svensson (2004), who extend the analysis to show formally that an independent central bank that cares about its balance sheet can also use real asset purchases as a commitment device). Finally, if the government accumulates large amounts of nominal debt, this, too, can be helpful in making an inflation pledge credible. However, the assumption of no credible commitment by the central bank, as implied by the benchmark policy rule here, is a useful benchmark for studying the usefulness of fiscal policy.

I think the assumption that the Fed cannot credibly commit to future inflation is a relevant benchmark in the present case since I am not sure that people believe that the government will actually create inflation in the future even if they promise to do so now. As I said in the original post, I think the inflation fighting credential the Fed has worked so hard to earn work against them in this instance. My point was that I didn't want to put all of my faith in one policy instrument -- monetary policy -- when theory and experience says that fiscal policy is the superior policy tool at the zero bound. Monetary policy alone might work, but again, if fiscal policy is available and these uncertainties exist, why take a chance? Why not use fiscal policy as well?

More generally, if people want to go back and use older or different models to make their arguments, that is fine, but it doesn't have a lot to do with the argument I was making. Perhaps they believe these models are superior to the models that Woodford and Eggertsson are using, that's certainly their prerogative, but which model provides better answers to the questions we are asking is a completely different argument. For the most part, the issues being raised about credibility have been considered and addressed within the New Keynesian framework.

Update: See Paul Krugman's comments, Policy And The Tinkerbell Principle.

CEGE Annual Conference: Financial Shocks and the Real Economy

I am here today:

CEGE Annual Conference
Financial Shocks and the Real Economy
Andrews Conference Room, 2203 Social Science/Humanities Building
University of California, Davis
Friday, May 7, 2010

8:30 Continental Breakfast

9:00 Financial Intermediation, Asset Prices, and Macroeconomic Dynamics

Tobias Adrian (NY Fed) (with Emanuel Moench and Hyun Song Shin)
Discussant: Oscar Jorda (UC Davis)

10:00 Credit Risk and the Macroeconomy

Simon Gilchrist (Boston University)
Discussant: Eric Swanson (Federal Reserve Bank of San Francisco)

11:00 Coffee Break

11:30 Financial Liberalization, Boom-Bust Cycles and Production Efficiency

Aaron Tornell (UCLA)
Discussant: Maurice Obstfeld (UC Berkeley)

12:30 Lunch Break

1:30 Macroeconomic Effects of Financial Shocks

Vincenzo Quadrini (USC) (with Urban Jermann)
Discussant: Michael Devereux (British Columbia)

2:30 Looking at Financial Crises in the Eye: Some Basic Observations

Guillermo Calvo (Columbia)
Discussant: Barry Eichengreen (UC Berkeley)

3:30 Coffee Break

4:00 Off the Cliff and Back? Credit Conditions and International Trade during the Global Financial Crisis

Kalina Manova (Stanford) (with Davin Chor)
Discussant: Dennis Novy (Warwick)

6:30 Dinner at Seasons Restaurant, 102 F Street

Sponsored by the Center for the Evolution of the Global Economy and the Institute of Governmental Affairs

"Life After 'Rational Expectations'?"

Critics of conventional macroeconomic models -- critics of the Rational Expectations and Efficient Markets Hypotheses in particular -- are often accused of simply rehashing old complaints (e.g. see the second paragraph of The Economist article mentioned below). This paper from the INET Conference attempts to depart from “familiar complaints” about REH and EMH. The paper argues that RE requires a mechanistic model of expectations that cannot possibly capture "the diversity of 'reasons' upon which individuals in real-world contexts might base their decisions," and then it offers an alternative approach to modeling expectations:

Life After "Rational Expectations"?, by Roman Frydman and Michael D. Goldberg [presentation slides]: Many people regard the recent financial crisis as a painful addition to an already massive body of evidence that demonstrates the inadequacy of today’s economic models of “rational” markets. ...

But very few have interpreted the inability of “rational” market models to account for such swings as a potentially decisive indication that economists’ approach to modeling rational decision-making is irreparably flawed. The debate triggered by the crisis, summarized by The Economist in two articles addressing “[w]hat went wrong with economics [a]nd how the discipline should change to avoid the mistakes of the past,” has largely overlooked the key problem: the impossibility of establishing a standard approach to modeling how a rational individual makes decisions in every situation.[1]

Precisely the presumption that economists’ have found such a standard has come to underpin models of rational decision-making in a wide variety of contexts – diverse economies, markets, and even fields of inquiry, such as political science and law. In order to arrive at such a universal approach, economists’ standard of rationality must abstract as much as possible from differences in individuals’ interpretations of the social context, including the process driving market outcomes, history, norms and conventions, and public policies and institutions. For the last three decades, the vast majority of economists, including those following the behavioral approach, have considered the “Rational Expectations Hypothesis” (REH) to be the cornerstone of this standard.

In this paper we sketch the emergence of REH and how it evolved to become the centerpiece of contemporary macroeconomics and finance. We focus on major arguments advanced by the promoters of the hypothesis that seemed to have contributed to its rapid and broad acceptance. We argue that REH models are fundamentally flawed on epistemological and empirical grounds and thus cannot serve as a foundation for thinking about markets and public policy.

Consequently, we urge economists to jettison REH. We have recently proposed an alternative approach, called Imperfect Knowledge Economics (IKE)...[2] In contrast to contemporary models, IKE recognizes the inherent limits to economists’ knowledge, as well as the imperfection of knowledge on the part of market participants and policy officials.[3] ...[P]sychological findings, as well as observations concerning the context within which participants make decisions – including historical market outcomes, past policies, norms, and conventions – play a key role in formalizing the foundations of IKE models.

Rationality and the Social Context

...For economists, “a decision-maker is rational if [she] makes decisions consistently in pursuit of [her] own objectives” (Myerson, 1991, p. 2). Economists typically suppose that individuals are motivated by self-interest, and thus that in making decisions they attempt to maximize their own well-being. Because selfishness is widely considered to be an innate trait, using self-interest to stand for decision-makers’ objectives is compatible with economists’ belief that their approach to rational decision-making is universally applicable.

The problem is that what constitutes self-interested decision-making depends on the context within which it occurs.[4] ... As Sen (1993, p. 501) has argued,

“[S]uppose the person faces a choice at a dinner table between having the last remaining apple in the fruit basket (option B) or leaving the apple for someone else to take and forgoing the opportunity of eating the nice-looking apple (option A). She decides to behave decently and picks nothing (option A), rather than one apple (option B). If, instead, the basket had contained two apples, and she had encountered the choice between having nothing (A), having one nice apple (B), [or having two nice apples] (option C), she could reasonably enough choose one (B), without violating any rule of good behavior.[5]

In checking whether these choices are internally consistent, economists would consider them on their own, without any reference to an individual’s values or the context within which she makes decisions. To be sure, if her sense of decency or some other reason were not behind her apparent preference for A in the first case and for B in the second, such choices would undeniably be inconsistent on purely logical grounds. But, as Sen (1993, p. 501) emphasizes, although this combination of choices would violate the standard consistency conditions, “[t]he presence of another apple (C) makes one of the two apples decently choosable. [T]here is nothing particularly ‘inconsistent’ in this pair of choices (given her values and scruples).” Indeed, as this example shows, “There is no such thing as internal consistency of choice” (Sen, 1993, p. 499).

"Effects of Fiscal Stimulus in Structural Models"

Phillip Lane of the Irish Economy blog notes a new IMF working paper on The Effects of Fiscal Stimulus in Structural Models. He says:

This new IMF working paper provides interesting analytical insights into the determinants of fiscal multipliers.  Also striking is the set of co-authors: it represents a joint collaborative effort across the IMF, ECB, European Commission, Federal Reserve, OECD and Bank of Canada.

Here are a few graphs from the report (I went overboard and there are 14 graphs below, most are on the continuation page to save space and reduce load time).

Interestingly, from the point of view of stimulating GDP, there is little difference between government investment and government consumption, and both work better than changes in taxes and transfers (one exception appears to be "targeted transfers")

[Note: if you cannot read the graphs, the models used are the EC's Quest, the IMF's GIMF, the ECB's NAWM, the Fed's FRB-US, the Fed's Sigma, and the BoC's GEM -- see the paper for more details. There are separate graphs for each of the seven fiscal policy instruments, the experiments are both with and without monetary accommodation, and both one year and two year stimulus packages are considered. Apologies for the space between the headers and the graphs -- it's in the originals]:

Financial Market Imperfections and Macroeconomics

I am here today:

Financial Market Imperfections and Macroeconomics Federal Reserve Bank of San Francisco 101 Market Street San Francisco, CA March 5, 2010

Morning Session Chair: Eric Swanson, Federal Reserve Bank of San Francisco
8:10 A.M.	Continental Breakfast
8:50 A.M.	Welcoming Remarks: Janet Yellen, Federal Reserve Bank of San Francisco
9:00 A.M.	Mark Gertler, New York University Nobuhiro Kiyotaki, Princeton University Financial Intermediation and Credit Policy in Business Cycle Analysis
	Discussant:	Lawrence Christiano, Northwestern University Simon Gilchrist, Boston University
10:20 A.M.	Break
10:40 A.M.	Vasco Cúrdia, Federal Reserve Bank of New York Michael Woodford, Columbia University Conventional and Unconventional Monetary Policy
	Discussants:	Robert Hall, Stanford University Noah Williams, University of Wisconsin, Madison
12:00 P.M.	Lunch – Market Street Dining Room, Fourth Floor
Afternoon Session Chair: Sylvain Leduc, Federal Reserve Bank of San Francisco
1:15 P.M.	Paul Beaudry, Oxford University Amartya Lahiri, University of British Columbia Risk Allocation, Debt Fueled Expansion and Financial Crisis
	Discussants:	David Lopez-Salido, Federal Reserve Board of Governors Martin Schneider, Stanford University
2:35 P.M.	Break
2:50 P.M.	Moritz Schularick, Free University of Berlin Alan Taylor, University of California, Davis Credit Booms Gone Bust: Monetary Policy, Leverage Cycles and Financial Crises, 1870-2008
	Discussants:	Pierre-Olivier Gourinchas, University of California, Berkeley Carmen Reinhart, University of Maryland
4:10 P.M.	Break
4:25 P.M.	Marco Del Negro, Federal Reserve Bank of New York Gauti Eggertsson, Federal Reserve Bank of New York Andrea Ferrero, Federal Reserve Bank of New York Nobuhiro Kiyotaki, Princeton University The Great Escape? A Quantitative Evaluation of the Fed’s Non-standard Monetary Policy
	Discussants:	James Hamilton, University of California, San Diego Zheng Liu, Federal Reserve Bank of San Francisco
5:45 P.M.	Reception – West Market Street Lounge, Fourth Floor
6:30 P.M.	Dinner – Market Street Dining Room, Fourth Floor Introduction: Janet Yellen, Federal Reserve Bank of San Francisco Speaker: Lars Svensson, Sveriges Riksbank

Chris Sims on Policy at the Zero Lower Bound

Chris Sims talks about difficulties of policy at the zero lower bound (wonkish). In particular, he discusses the difficulty of credible commitment to higher future inflation that is necessary in most New Keynesian models, the difficulty in achieving fiscal and monetary policy coordination, and the problems that may arise when the central bank takes quasi-fiscal actions:

Commentary on Policy at the Zero Lower Bound, by Christopher A. Sims, Princeton University, CEPS Working Paper No. 201, January 2010: I. ROBUST IMPLICATIONS OF CONVENTIONAL NEW KEYNESIAN MODELS FOR POLICY AT THE ZERO LOWER BOUND Monetary policy has been thought of, at least for several decades up until the fall of 2008, as interest rate policy. Certainly New Keynesian policy models treat it this way. At the zero lower bound (ZLB), the interest rate is stuck, so long as policy makers would like to be taking a more stimulative stance. This would seem on the face of it to imply that monetary policy is paralyzed. New Keynesian models like those in this volume generally agree that monetary policy can be effective, though, if policy can take the form of credible commitments to future interest rate paths. This optimistic conclusion was developed by Christiano, Motto, and Rostagno (2004), Eggertsson and Woodford (2003), and Eggertsson (2008), and emerges in this volume’s papers as well.

But the conclusion is less optimistic than it looks. In models, it is easy to specify an announced future policy stance and assume the public believes the announcement. In practice, there is inevitably uncertainty about exactly how firm are commitments to future policy, even if the future policy is announced in detail. The uncertainty implies volatility, as newly arriving information shifts the public’s perception of how easy it will be to deliver on the commitment.

Central banks in most developed countries have succeeded in convincing the public that they are committed to maintaining low and stable inflation. But this credibility has built up over decades as the central banks have acted to deliver on their commitment. In the presence of a binding ZLB, the result from the models is that the central bank ought to commit to expansionary future policy. A bank that has built up inflation-fighting credibility may find this is a liability if it tries to convince the public that it is temporarily committed to increasing the inflation rate.

Announcements about future policy at a time when the short rates that ordinarily are seen as set by the central bank are stuck at zero are particularly subject to doubt, just because they are accompanied by no current action.

Leverage Cycles

[Warning: Wonkish] I've said several times recently that I favor limiting leverage as one of the responses to the financial crisis, but I haven't talked a lot about the theoretical underpinnings for this view. Fortunately, Rajiv Sethi describes one of the papers in this area that helped to convince me that limiting leverage cycles is important. I've also included a summary of another paper by Ana Fostel and John Geanakoplis on the same topic from an interview of Eric Maskin (The paper has several attractive features. It is a general equilibrium model, it has heterogeneous agents, incomplete markets, and asymmetric information, and it can generate endogenous leverage cycles that can lead to a collapse of the banking sector. But it is just one in a series of papers on the topic, with the most recent described next):

John Geanakoplos on the Leverage Cycle, by Rajiv Sethi: In a series of papers starting with Promises Promises in 1997, John Geanakoplos has been developing general equilibrium models of asset pricing in which collateral, leverage and default play a central role. This work has attracted a fair amount of media attention since the onset of the financial crisis. While the public visibility will surely pass, I believe that the work itself is foundational, and will give rise to an important literature with implications for both theory and policy.

The latest paper in the sequence is The Leverage Cycle, to be published later this year in the NBER Macroeconomics Annual. Among the many insights contained there is the following: the price of an asset at any point in time is determined not simply by the stream of revenues it is expected to yield, but also by the manner in which wealth is distributed across individuals with varying beliefs, and the extent to which these individuals have access to leverage. As a result, a relatively modest decline in expectations about future revenues can result in a crash in asset prices because of two amplifying mechanisms: changes in the degree of equilibrium leverage, and the bankruptcy of those who hold the most optimistic beliefs.

This has some rather significant policy implications:

''The Behavioralist Visits the Factory''

A test of prospect theory:

The Behavioralist Visits the Factory: Increasing Productivity Using Simple Framing Manipulations, by Tanjim Hossain, John A. List, NBER Working Paper No. 15623, Issued in December 2009: Abstract: Recent discoveries in behavioral economics have led to important new insights concerning what can happen in markets. Such gains in knowledge have come primarily via laboratory experiments—a missing piece of the puzzle in many cases is parallel evidence drawn from naturally-occurring field counterparts. We provide a small movement in this direction by taking advantage of a unique opportunity to work with a Chinese high-tech manufacturing facility. Our study revolves around using insights gained from one of the most influential lines of behavioral research—framing manipulations—in an attempt to increase worker productivity in the facility. Using a natural field experiment, we report several insights.

This paragraph from the introduction describes the experiment:

During our experiment, which lasted almost six months in total, subjects engaged in their regular tasks, and had standard work schedules. As per company policy, the bonus incentives were paid in addition to the base income, and employees were notified of the bonuses via personal letters. The main insights gained in the experiment come from a comparison of productivity measures across a baseline and two treatments: in the positively framed bonus ("reward") treatment employees are notified that if the week’s average per-hour production reaches a certain threshold, a bonus is paid at the end of the pay period. In the negatively framed bonus ("punishment") treatment, employees are provisionally given the bonus before the work week begins, but are notified that if the average per-hour production does not reach a certain threshold, it is retracted at the end of the pay period. In this way, the bonus schemes are isomorphic, except for the frame. Nevertheless, prospect theory conjectures that since losses loom larger than gains, the punishment treatment should outperform the reward variant. Alternatively, if workers are more invigorated by positive incentive schemes, the reward treatment should lead to a higher level of productivity.

Back to the abstract:

...conditional incentives framed as both “losses” and “gains” increase productivity for both individuals and teams. In addition, teams more acutely respond to bonuses posed as losses than as comparable bonuses posed as gains. The magnitude of the effect is roughly 1%: that is, total team productivity is enhanced by 1% purely due to the framing manipulation. Importantly, we find that neither the framing nor the incentive effect lose their importance over time; rather the effects are observed over the entire sample period. Moreover, we learn that worker reputation and conditionality of the bonus contract are substitutes for sustenance of incentive effects in the long-run production function.

"The Economics and Policy of Illegal Immigration in the United States"

Gordon Hanson on illegal immigration:

The Economics and Policy of Illegal Immigration in the United States, by Gordon H. Hanson: Executive Summary Policymakers across the political spectrum share a belief that high levels of illegal immigration are an indictment of the current immigration policy regime. An estimated 12 million unauthorized immigrants live in the United States, and the past decade saw an average of 500,000 illegal entrants per year. Until recently, the presence of unauthorized immigrants was unofficially tolerated. But since 2001, policymakers have poured huge resources into securing US borders, ports, and airports; and since 2006, a growing range of policies has targeted unauthorized immigrants within the country and their employers.

Notwithstanding these efforts, no agreement has materialized on a system to replace the status quo and, in particular, to divert illegal flows to legal ones. Policy inaction is a result not only of a partisan divide in Washington, but also of the underlying economic reality that despite its faults, illegal immigration has been hugely beneficial to many US employers, often providing benefits that the current legal immigration system does not.

"Immigration, Wages, and Compositional Amenities"

Why do people oppose immigration? Here's the introduction and part of the conclusion to a recent paper on this topic by David Card, Christian Dustmann, and Ian Preston. The bottom line is that the effects of immigration on wages and taxes -- to the extent that such effects exist -- are of concern, but according to this research it is not the primary objection:

Immigration, Wages, and Compositional Amenities, by David Card, Christian Dustmann, and Ian Preston, NBER Working Paper No. 15521, November 2009 [Open Link]: Introduction Standard economic reasoning suggests that immigration, like trade, creates a surplus that in principle can be redistributed so all natives are better off (Mundell, 1957). In practice the redistributive mechanisms are incomplete so both policies tend to create winners and losers. Even so, public support for increased immigration is far weaker than for expanding trade.[1] While the two policies have symmetric effects on relative factor prices, immigration also changes the composition of the receiving country’s population, imposing externalities on the existing population. Previous studies have focused on the fiscal externalities created by redistributive taxes and benefits (e.g., MaCurdy, Nechyba, and Bhattacharya, 1998; Borjas, 1999, Hanson, Scheve and Slaughter, 2005). A wider class of externalities arise through the fact that people value the ‘compositional amenities’ associated with the characteristics of their neighbors and co-workers. Such preferences are central to understanding discrimination (Becker, 1957) and choices between neighborhoods and schools (e.g., Bayer, Ferreira, and McMillan, 2007) and arguably play an important role in mediating views about immigration.

This paper presents a new method for quantifying the relative importance of compositional amenities in shaping individual attitudes toward immigration. The key to our approach is a series of questions included in the 2002 European Social Survey (ESS) that elicited views on the effects of immigration on specific domains – including impacts on relative wages and the fiscal balance, and a country’s culture life – as well as on the importance of maintaining shared religious beliefs, language, and customs. ...

Our empirical analysis leads to three main conclusions. First, we find that attitudes to immigration – expressed by the answer to a question of whether more or fewer immigrants from certain source countries should be permitted to enter, for example – reflect a combination of concerns over compositional amenities and the direct economic impacts of immigration on wages and taxes. Second, we find that the strength of the concerns that people express over the two channels are positively correlated. This means that studies that focus exclusively on one factor or the other capture a reasonable share of the variation in attitudes for or against increased immigration.[2]

Our third conclusion is that concerns over compositional amenities are substantially more important than concerns over the impacts on wages and taxes.[3] Specifically, variation in concerns over compositional amenities explain 3-5 times more of the individual-specific variation in answers to the question of whether more or fewer immigrants should be permitted to enter than does variation in concerns over wages and taxes. Concerns over compositional amenities are even more important in understanding attitudes toward immigrant groups that are ethnically different, or come from poorer countries. Similarly, differences in concerns over compositional amenities account for about 70% of the gap between high- and low-education respondents over whether more immigrants should be permitted to enter the country.

Interestingly, concerns over the direct economic impacts of immigration explain a much larger share of variation in responses to a summary question of whether immigration is good or bad for the economy. The contrast suggests that respondents make a distinction between the wage and tax effects of immigration and the effects on the composition of the host country, and place substantial weight on the latter in forming overall views about immigration policies. ...

Differences in compositional concerns also explain most of the differences in attitudes between older and younger respondents. The age gap is a particular puzzle for models of immigration preferences that ignore compositional amenities, because many older people are retired, and face a much lower threat of labor market competition than young people.

While our inferences are based on purely observational data, and rely on a restrictive structural model, we present a number of robustness checks and extensions that support our general conclusions about the importance of compositional concerns. ...

What’s Wrong with Modern Macroeconomics? - Conference Papers

What’s Wrong with Modern Macroeconomics?

CESifo Conference Centre, Munich
6 - 7 November 2009

Programme

Friday, 6 November 2009

Session I
Chair: Gerhard Illing

09:00 – 09:50 The Roles of Ideology, Institutions, Politics and Economic Knowledge in Forecasting Macroeconomic Developments
ALEX CUKIERMAN (Tel-Aviv University) (via video link)
Discussant: Panu Poutvaara (University of Helsinki)

09:50 – 10:40 Uncertainty, Risk-taking and the Business Cycle
FRANK SMETS (ECB)
Discussant: Camilo E. Tovar

Session II
Chair: Efraim Sadka

11:00 - 11:50 Macroeconomic Agenda: Compare Competing Paradigms and Identify Robust Policy Recommendations
VOLKER WIELAND (Goethe University Frankfurt)
Discussant: Antonio Spilimbergo (IMF)

11:50 – 12:40 Liquidity Constraints and Non-market Clearing: A Recipe for Recession?
John Drifill and MARCUS MILLER (University of Warwick)
Discussant: Jouko Vilmunen (Bank of Finland)  

Session III
Chair: Paul de Grauwe

14:00 – 14:50 Analysis of Monetary Policy and Financial Stability: A New Paradigm
Charles Goodhart, Carolina Osorio and DIMITRI TSOMOCOS (Oxford University)
Discussant: Daniel Gros (Center for European Policy Studies)

14:50 – 15:40 Unemployment Risk and Aggregate Consumption Behaviour
XAVIER RAGOT (Banque de France) and Edouard Challe
Discussant: Efraim Sadka (Tel-Aviv University)

Panel discussion
Moderator: Robert M. Solow
Panellists: Hans Gersbach, Charles Goodhart, Hans-Werner Sinn, Mark Thoma, Martin Wolf 

Saturday, 7 November 2009

Session IV
Chair: Volker Wieland

8:30 – 9:10  Top Down or Bottom Up Macroeconomics
PAUL DE GRAUWE (University of Leuven)
Discussant: Casper de Vries (University Rotterdam)

9:10 – 9:50 The Economic Crisis is a Crisis for Economic Theory
ALAN KIRMAN (G.R.E.Q.A.M.)
Discussant: Mark Thoma (University of Oregon)

9:50 – 10:30 Reconstucting Macroeconomics: More is Different
THOMAS LUX (University of Kiel)
Discussant: Pablo Rovira Kaltwasser (University of Leuven)

Session V
Chair: Hans Gerbach

10:50 – 11:30 The Banking Crisis - Capitalism's Business as Usual
PATRICK MINFORD (Cardiff University)
Discussant: Sebastian Watzka (University of Munich)

11:30 – 12:10 What's Wrong with Modern Macroeconomics? Why its Critics Have Missed the Point
MIKE WICKENS (York University)
Discussant: Hans Dewachter (University of Leuven)

12:10 – 13:00 General Discussion

"250 Years of Clever Counting"

Stephen Ziliak emails:

Only moralists and economists know that Adam Smith's Theory of Moral Sentiments (1759) turned 250 years old this year. 

However worthy an Adam Smith party, I thought you'd like to know about another party and sentiment, "Arthur's Day" - the Guinness Brewery's 250th birthday party - to be celebrated Thursday, September 24th, all over the world:

My article, "Great Lease, Arthur Guinness - Lovely Day for a Gosset!" (prepared for a special "Beeronomics" issue of the Journal of Wine Economics), shows how clever counting at Guinness did not stop two and a half centuries ago when Arthur signed a 9,000 year lease for the brewery, house, and land at St. James's Gate in exchange for 45 pounds a year (nominal, not inflation adjusted)!

"The great innovation in statistics in the era after Galton and Pearson was made in the private sector of the economy, between 1904 and 1937, at Guinness's Laboratory, to the end of improving, however gradually, production of a consistent beer at efficient economies of scale" (Ziliak 2009, p. 4).

Here's the article "Great Lease, Arthur Guinness—Lovely Day for a Gosset!":

Abstract: Small sample theory—the great innovation in statistical method in the period after Galton and Pearson—was ironically discovered by a brewer during routine work performed at a large brewery, Arthur Guinness, Son & Company, Ltd. For four decades William S. Gosset applied small sample experiments to the palpable end of improving, however gradually, the production and control of a consistent unpasteurized beer when packaged and sold at efficient economies of scale. Introducing, "Guinnessometrics." Annual output of stout at Guinness’s Brewery may have topped 100 million gallons but Gosset’s scientific knowledge was built one barleycorn at a time; in fact, the inventor of small sample theory worked closely with botanists and breeders. In the process, the brewer, William Sealy Gosset (1876-1937) aka "Student," an Oxford-trained chemist—though self-trained in statistics—solved a problem in the classical theory of errors which had eluded statisticians from Laplace to Pearson. In addition, though few have noticed, Gosset’s exacting theory of errors, both random and real, marked a significant advance over ambiguous reports of plant life and fermentation asserted by chemists from Priestley and Lavoisier down to Pasteur and Johannsen, working at the Carlsberg Laboratory. Central to the Guinness brewer’s success was his persistent economic interpretation of uncertainty, what Ziliak and McCloskey (2008) call the "size matters/how much" question of any series of experiments. An enlightened change in Guinness human resources policy gave an incentive structure that also seems to have nudged "Student," who rose in position to Head Brewer, to find a profit when the opportunity knocked. Beginning in 1893, Guinness vested "scientific brewers" such as Gosset with managerial authority. In fact Gosset was at times involved with price negotiations over hundreds of tons of barley and hops—perhaps hours or minutes before he ran (that is, calculated) a regression on related material. In brewing circles William Gosset is remembered less nowadays than he might be. He did not give two cents for arbitrary rules about statistical significance—at the 5% level or any level arbitrarily assumed. How the odds should be set depends on the importance of the issues at stake and the cost of getting new material, he said from 1904. Yet even in brewing journals, both academic and trade, and for the past 85 years, statistical significance at the 5% level continues to draw its arbitrary line segregating a meaningful from a non-meaningful result, a better barley from a worse.

"Surprising Comparative Properties of Monetary Models"

I need to read this paper:

Surprising Comparative Properties of Monetary Models: Results from a New Data Base, by John B. Taylor and Volker Wieland, May 2009 [open link]: Abstract: In this paper we investigate the comparative properties of empirically-estimated monetary models of the U.S. economy. We make use of a new data base of models designed for such investigations. We focus on three representative models: the Christiano, Eichenbaum, Evans (2005) model, the Smets and Wouters (2007) model, and the Taylor (1993a) model. Although the three models differ in terms of structure, estimation method, sample period, and data vintage, we find surprisingly similar economic impacts of unanticipated changes in the federal funds rate. However, the optimal monetary policy responses to other sources of economic fluctuations are widely different in the different models. We show that simple optimal policy rules that respond to the growth rate of output and smooth the interest rate are not robust. In contrast, policy rules with no interest rate smoothing and no response to the growth rate, as distinct from the level, of output are more robust. Robustness can be improved further by optimizing rules with respect to the average loss across the three models.

"The New Kaldor Facts"

What does growth theory need to explain? Has there been progress?:

The New Kaldor Facts: Ideas, Institutions, Population, and Human Capital, by Charles I. Jones and Paul M. Romer, NBER WP 15094, June 2009 [open link]: 1. Introduction ...[I]t is easy to lose faith in scientific progress. ... In any assessment of progress, as in any analysis of macroeconomic variables, a long-run perspective helps us look past the short-run fluctuations and see the underlying trend. In 1961, Nicolas Kaldor stated six now famous “stylized” facts. He used them to summarize what economists had learned from their analysis of 20th-century growth and also to frame the research agenda going forward (Kaldor, 1961):

1. Labor productivity has grown at a sustained rate.
2. Capital per worker has also grown at a sustained rate.
3. The real interest rate or return on capital has been stable.
4. The ratio of capital to output has also been stable.
5. Capital and labor have captured stable shares of national income.
6. Among the fast growing countries of the world, there is an appreciable variation in the rate of growth “of the order of 2–5 percent.”

Redoing this exercise nearly 50 years later shows just how much progress we have made. Kaldor’s first five facts have moved from research papers to textbooks. There is no longer any interesting debate about the features that a model must contain to explain them. These features are embodied in one of the great successes of growth theory in the 1950s and 1960s, the neoclassical growth model. Today, researchers are now grappling with Kaldor’s sixth fact and have moved on to several others that we list below.

"The Paradox of Declining Female Happiness"

Why has women's happiness declined relative to men's?:

The Paradox of Declining Female Happiness, by Betsey Stevenson and Justin Wolfers, NBER Working Paper No. 14969, May 2009 [open link]: Abstract By many objective measures the lives of women in the United States have improved over the past 35 years, yet we show that measures of subjective well-being indicate that women’s happiness has declined both absolutely and relative to men. The paradox of women’s declining relative well-being is found across various datasets, measures of subjective well-being, and is pervasive across demographic groups and industrialized countries. Relative declines in female happiness have eroded a gender gap in happiness in which women in the 1970s typically reported higher subjective well-being than did men. These declines have continued and a new gender gap is emerging—one with higher subjective well-being for men.

Inequality and Residential Segregation

According to this research, inequality raises residential segregation. This is worrisome in part because the increase in segregation can cause problems that feedback to both amplify and perpetuate the inequality:

Inequality and the Measurement of Residential Segregation by Income In American Neighborhoods, by Tara Watson,  NBER Working Paper No. 14908, April 2009: Abstract American metropolitan areas have experienced rising residential segregation by income since 1970. One potential explanation for this change is growing income inequality. However, measures of residential sorting are typically mechanically related to the income distribution, making it difficult to identify the impact of inequality on residential choice. This paper presents a measure of residential segregation by income, the Centile Gap Index (CGI) which is based on income percentiles. Using the CGI, I find that a one standard deviation increase in income inequality raises residential segregation by income by 0.4-0.9 standard deviations. Inequality at the top of the distribution is associated with more segregation of the rich, while inequality at the bottom and declines in labor demand for less-skilled men are associated with residential isolation of the poor. Inequality can fully explain the rise in income segregation between 1970 and 2000. ...

Do Changes in Consumer Confidence Reflect Animal Spirits or Information?

There are two views of changes in consumer confidence, the animal spirits view where causality runs from changes in confidence to changes in economic activity, and the information view where changes in confidence are due to the arrival of new information about future productivity. Suppose, for example, that agents in the economy are able to observe information about future productivity, but the econometrician cannot. In this case, when new information about future output arrives, confidence will change. However, since the econometrician cannot see the information about future output, and instead only sees changes in confidence followed by changes in changes in real activity, if the information view is not considered, then the econometrician will wrongly conclude that animal spirits cause future economic activity. Ultimately, however, which view is correct - the animal spirits view, the information view, or something else entirely - is an empirical question. Here's an attempt to settle it:

Information, Animal Spirits, and the Meaning of Innovations in Consumer Confidence, by Robert B. Barsky and Eric R. Sims: Abstract Innovations to measures of consumer confidence convey incremental information about economic activity far into the future. Comparing the shapes of impulse responses to confidence innovations in the data with the predictions of a calibrated New Keynesian model, we find little evidence of a strong causal channel from autonomous movements in sentiment to economic outcomes (the "animal spirits" interpretation). Rather, these impulse responses support an alternative hypothesis that the surprise movements in confidence reflect information about future economic prospects (the "information" view). Confidence innovations are best characterized as noisy measures of changes in expected productivity growth over a relatively long horizon.

I. Introduction

In the popular press and much of the business community it continues to be an article of faith that "consumer confidence" has an important role – both prognostic and causal – in macroeconomics. On the other hand, the stance of the rather limited academic literature on confidence is far more ambiguous. The judgments range from the conclusion that confidence measures have an important role both in prediction and understanding the cause of business cycles, to the view that they contain important information but have little role in the assignment of causality, to the verdict that they have no value even in forecasting.

There are, broadly speaking, two contrasting approaches to the role of confidence in macroeconomics.

Short-Sighted?

According to this research, welfare reform caused adult women to reduce their education:

Welfare reform undermined, Free Exchange: Getting poor mothers off welfare and into employment as quickly as possible seems to be a useful policy goal. But a new paper by economists Dhaval Dave, Nancy E Reichman, and Hope Corman suggests it can be short-sighted.

The Personal Responsibility and Work Opportunity Reconciliation Act of 1996 limited the time mothers could spend on welfare and required some work as a condition for receiving it. The reforms were, by most measures, successful at reducing the number of women on welfare and increasing their levels of employment. ... But..., the authors ... found that the reforms made adult women less likely to pursue education.

The reforms do not penalise minor (under 18) women who still attend school. Actually, the reforms encourage the younger women to finish their education. To receive some of the government funds, single, minor mothers must attend high school or some training program. The authors found this incentive decreased the teen dropout rates of the population between 9 and 13%.

By contrast, the reforms aimed at adult women, which promoted work and not training, made education less attractive. The authors found the reforms decreased the probability of adult women attending high school or college by 20 to 25%.

The number of welfare claims unambiguously decreased, but at what cost? More education increases the value of your human capital which leads to higher wages and more self-sufficiency. The authors wonder if discouraging education might ultimately leave the women more dependent on state benefits than they would if education were encouraged. The trade-off is a classic example of the choice of short-term gain and long-term pain.

Krugman: The International Finance Multiplier

Paul Krugman develops an "international finance multiplier" that works through key leveraged intermediaries that connect countries together financially. His model shows that under capitalization, not liquidity is the main problem to be solved, and that "there are large cross-border externalities in financial rescues":

1. The International Finance Multiplier, Paul Krugman, October 2008: 1. Introduction The current financial crisis is remarkable in many ways, but one aspect is of special interest for international economists: even though the roots of the crisis lie in the U.S. housing market, the crisis is now very much a global affair. Figure 1 shows the decline in a number of stock market indices over the year ending October 4, 2008; essentially, all markets fell by the same amount.

The freeze on interbank lending and in the commercial paper market is affecting Europe to much the same degree that it’s affecting the United States, with the gap between Euribor and the repo rate similar to that between Libor and the Fed funds rate. Banks are failing, or needing urgent government rescue, on both sides of the Atlantic.

International economists have been interested in interdependence for a very long time – arguably too interested. Global interdependence is one of those topics people love to talk about because it sounds sophisticated – the Wall Street Journal once published a piece mocking Multilateral Man, who wants to cooperate to improve coordination and coordinate to improve cooperation. (This is as opposed to Euro Man, who wants cohesion to promote convergence …)

But the interdependence this time is real – and it seems to be operating through channels that are not yet part of standard international macro analysis. Much thinking about international linkages still relies on some version of the traditional foreign trade multiplier: country A’s GDP affects its level of imports, which are country B’s exports, so demand shocks get transmitted through international trade. As I’ll explain shortly, however, this won’t work for current events. Instead we seem to be dealing with a phenomenon I’ll call the international finance multiplier, in which changes in asset prices are transmitted internationally through their effects on the balance sheets of highly leveraged financial institutions. ...

Before we get there, however, let’s review the traditional analysis of interdependence.

"Distributional Effects of Environmental and Energy Policy: An Introduction"

Is it true that many of the effects of environmental policy are likely regressive? According to this, the answer is yes, but rebates to low-income households can offset the regressive effects. "This makes it important to use emissions taxes or the auction of permits, to raise revenue enough to cover the cost of those rebates":

Distributional Effects of Environmental and Energy Policy: An Introduction, by Don Fullerton, NBER Working Paper No. 14241 August 2008: Public economics has well developed tools for analyzing the incidence and distributional effects of ... taxes. ... Yet most pollution policy does not involve taxation at all. Instead, it employs permits or command and control (CAC) regulations such as technology standards, quotas, and other quantity constraints. ...

CAC environmental restrictions do impose costs, and an important question is who bears those costs. Moreover, those restrictions provide benefits of environmental protection, and another important question is who gets those benefits. Thus, full analysis of environmental policy could address all the same questions as in the tax incidence literature. ...

This introduction discusses some initial literature on distributional effects of environmental and energy policy. ... To identify the major effects around which this introduction is organized, consider a simple requirement that electric generating companies cut a particular pollutant to less than some maximum quota. This type of mandate is a common policy choice, and it has at least the following six distributional effects.

"That Chain E-mail Your Friend Sent to You Is (Likely) Bogus"

I get lots of questions on the claims made about economic issues in chain email pertaining to the election, and from what I've heard and from the evidence noted below, the email seems to mostly target Democrats.

I've been wondering about their effectiveness. Most of the time the claims are false or highly misleading, yet from casual observation they seem to work (don't take my word that they are mostly false, see "That Chain E-mail Your Friend Sent to You Is (Likely) Bogus. Seriously." Note that this also says "We have yet to see e-mails about John McCain, and Emery notes a decidedly anti-Democrat tilt to the bulk of the e-mail chatter.").

I don't know of any formal studies about the effectiveness of chain email (anyone?), but I did come across this NBER study of snail mail indicating that direct messaging does impact voter preferences (note, however, a point from the conclusion that the recipients of the mail were pre-selected based upon the likelihood they might be the type of voter who would change their minds, so the effect on a randomly selected voter would be smaller):

The Persuasive Effects of Direct Mail: A Regression Discontinuity Approach, by Alan Gerber, Daniel Kessler, and Marc Meredith, NBER WP 14206, July 2008 [Open Link]: 1. Introduction ...In this paper, we use a regression discontinuity (RD) approach to identify the effects on campaign activity on turnout and vote share. ... During the contest for Kansas attorney general in 2006, an organization sent out 6 pieces of mail criticizing the Republican incumbent’s conduct in office. We obtained a complete record of which households received the mailings as well as the algorithm used to select the households ... that received the mail. ... We exploit our knowledge of the selection rule to isolate a discontinuity in the targeting algorithm which resulted in substantially different amounts of mail in otherwise similar precincts. ... We find that the 6 piece mail campaign had no effect on turnout but caused a sizable increase in the vote share of the Democratic challenger. ...

7. Conclusion ...Our estimates suggest that a ten percentage point increase in the amount of mail sent to a precinct increased the Democratic challenger’s vote share by about three percentage points. Furthermore, we find no evidence that these mailings affected turnout. As a result, we conclude that these mailings persuaded individuals who were already going to turnout to switch...

These effects are quite large. ... There is only limited evidence on the persuasive effects of direct mail campaigns, but previous studies find much smaller effects... A number of factors might account for this difference. ...[T]he particular race we study is a down-ballot race; it was not the primary race mobilizing voters to the polls. Direct mail likely has a larger potential effect in such environment than in a presidential race where voters are much better informed about the issues. Third, the ... treatment effect we estimate only applies to so-called "mail eligible" voters -- namely, those who were predetermined by the vendor to be particularly susceptible to persuasion; mail almost surely would be less effective in the population at large. ...

Better informed in a presidential race? That brings us back to the chain email. Where does this email come from, and why is it so one-sided? Is it an organized effort? The email is under the radar for the most part, a somewhat silent, continuous stream of lies that flows into who knows how many inboxes every day - at best it is highly misleading information (again, see the link above) - information that is rarely rebutted effectively within the same information networks, and I wonder what impact it has on the spread of effective narratives and, ultimately, on votes.

Update: From a link provided in comments, more here:

The e-mail landed in Danielle Allen's queue one winter morning as she was studying in her office at the Institute for Advanced Study, the renowned haven for some of the nation's most brilliant minds. The missive began: "THIS DEFINITELY WARRANTS LOOKING INTO."

Laid out before Allen, a razor-sharp, 36-year-old political theorist, was what purported to be a biographical sketch of Barack Obama that has become one of the most effective -- and baseless -- Internet attacks of the 2008 presidential season. The anonymous chain e-mail makes the false claim that Obama is concealing a radical Islamic background. By the time it reached Allen on Jan. 11, 2008, it had spread with viral efficiency for more than a year.

During that time, polls show the number of voters who mistakenly believe Obama is a Muslim rose -- from 8 percent to 13 percent between November 2007 and March 2008. And some cited this religious mis-affiliation when explaining their primary votes against him. ...

Allen studies the way voters in a democracy gather their information and act on what they learn. She was familiar, of course, with the false rumors of a secret love child that helped sink McCain's White House bid in 2000, and the Swift boat attacks that did the same to Democrat John Kerry in 2004. But the Obama e-mail was on another plane: The use of the Internet made it possible to launch anonymous attacks that could reach millions of voters in weeks or even days. ...

Allen set her sights on dissecting the modern version of a whisper campaign, even though experts told her it would be impossible to trace the chain e-mail to its origin. Along the way, even as her hunt grew cold, she gained valuable insight into the way political information circulates, mutates and sometimes devastates in the digital age. ...

"The 'Big Push' and Economic Development in the American South"

David Beckworth on evidence for The Big Push theory of economic development, the idea that "publicly coordinated investment can break the underdevelopment trap by helping economies overcome deficiencies in private incentives that prevent firms from adopting modern production techniques and achieving scale economies." Given recent debate over using infrastructure spending as a means of stimulating the economy, the long-run supply-side effects of stimulating the economy through spending on infrastructure are noteworthy:

The 'Big Push' and Economic Devlopment in the American South, by David Beckworth: One of the great stories from 20th century U.S. economic history is the great economic rebound of the American South. From the close of the Civil War up through World War II, this region’s economy had been relatively undeveloped and isolated from the rest of the country. This eighty-year period of economic backwardness in the South stood in stark contrast to the economic gains elsewhere in the country that made the United States the leading industrial power of the world by the early 20th century. Something radically changed, though, in the 1930s and 1940s that broke the South free from its poverty trap. From this period on, the South began modernizing and by 1980 it had converged with the rest of the U.S. economy. But why the sudden break in the 1930-1940 period? A new paper by Fred Bateman, Jaime Ros, and Jason E. Taylor provides a fascinating answer: the economic rebound of American South was the result of a 'Big Push' from large public capital investments during the Great Depression and World War II.

A novel contribution of this paper is that it appears to provide a real-world example of the 'Big Push' theory. Never heard of the 'Big Push' theory? Well, here is how the authors describe it:

"Housing Supply and Housing Bubbles"

Edward Glaeser, Joseph Gyourko, and Albert Saiz construct a model of housing bubbles that is consistent with movements in housing prices and quantities during the two most recent housing bubbles (the current episode and the prior episode in the 1980s). Looking at the data, they note that areas with inelastic housing supply had large price run-ups and subsequent long, drawn out crashes in both episodes. However, "The fact that highly elastic places had price booms is one of the strange facts about the recent price explosion." Because it is unprecedented, there is considerable uncertainty about how much prices might fall in the areas where supply is elastic. However, using the model as a guide, they find that "If these markets return to their historical norm..., then they will experience further sharp price declines," though there is a lot of uncertainty surrounding this prediction.

Maybe another way to think about this is that in some areas, those areas where supply is termed inelastic, the quantity response is essentially symmetric -- housing supply moves sluggishly whether prices are rising or falling. However, other areas could have housing supply that responds elastically when prices are rising (though sometimes there can be bubbles in these markets anyway - see below), but inelastically when prices are falling. In these markets, housing comes online relatively easily when prices are rising, but quantity responds much more sluggishly when prices fall, and the response could be similar to the symmetrically inelastic cases.

Why might the two sets of markets have similar responses on the down-side? Think about the inelastic markets where supply cannot increase due to geographic limitations (they use a geographic measure to sort the data). Geography limits the expansion of housing, but when there is an oversupply of housing, geography does not prevent the supply from falling, so it must be something else that prevents quantity adjustment and whatever it is could certainly be present in markets where geography is not an issue  (i.e. the markets that are elastic when prices rise). If this is right, then there's reason to believe that the two sets of markets will generate similar responses for price and quantity on the down-side, and this would explain the finding in the paper that "elasticity was uncorrelated with either price or quantity changes during the bust" (so long as other factors such as regulation are similar, e.g., it's equally easy to replace a house with a restaurant after remodeling in the two markets). This would mean that - as predicted (with qualifications) in the paper - the elastic markets may mimic the inelastic markets and be in for a sharp price decline.

One more note from the paper about elastic markets, "Even though elastic housing supply mutes the price impacts of housing bubbles, the social welfare losses of housing bubbles may be higher in more elastic areas, since there will be more overbuilding during the bubble." Thus, it's possible for markets with sharp price adjustments to fare better in a welfare sense than markets where price changes are more muted. Here's some of the introduction from the paper [can anyone find an open link?] [Update: Richard Green: Mark Thoma thinks housing supply elasticities may be asymmetric ... I have reason to think Mark is right. My 2005 paper with Mayo and Malpezzi found evidence of this; cities that appeared inelastic included Pittsburgh, Toledo, Albany, Buffalo and Providence. None of these cities had upward pressure on housing production; rather, they were losing population and the housing stock took a long time to adjust to the loss.]:

Housing Supply and Housing Bubbles, by Edward L. Glaeser, Joseph Gyourko, and Albert Saiz, NBER WP 14193, July 2008: Introduction In the 25 years since Shiller (1981) documented that swings in stock prices were extremely high relative to changes in dividends, a growing body of papers has suggested that asset price movements reflect irrational exuberance as well as fundamentals (DeLong et al., 1990; Barberis et al., 2001). A running theme of these papers is that high transactions costs and limits on short-selling make it more likely that prices will diverge from fundamentals. In housing markets, transactions costs are higher and short-selling is more difficult than in almost any other asset market (e.g., Linneman, 1986; Wallace and Meese, 1994; Rosenthal, 1989). Thus, we should not be surprised that the predictability of housing price changes (Case and Shiller, 1989) and seemingly large deviations between housing prices and fundamentals create few opportunities for arbitrage.

The extraordinary nature of the recent boom in housing markets has piqued interest in this issue, with some claiming there was a bubble (e.g., Shiller, 2005). While nonlinearities in the discounting of rents could lead prices to respond sharply to changes in interest rates in particular in certain markets (Himmelberg et al., 2005), it remains difficult to explain the large changes in housing prices over time with changes in incomes, amenities or interest rates (Glaeser and Gyourko, 2006). It certainly is hard to know whether house prices in 1996 were too low or whether values in 2005 were too high, but it is harder still to explain the rapid rise and fall of housing prices with a purely rational model.

However, the asset pricing literature long ago showed how difficult it is to confirm the presence of a bubble (e.g., Flood and Hodrick, 1990). Our focus here is not on developing such a test, but on examining the nature of bubbles, should they exist, in housing markets.

"Immigration and National Wages: Clarifying the Theory and the Empirics"

Gianmarco I.P. Ottaviano and Giovanni Peri on immigration and wages:

Immigration and National Wages: Clarifying the Theory and the Empirics, Gianmarco I.P. Ottaviano, Giovanni Peri. NBER WP No. 14188,
Issued in July 2008 [open link]: Abstract This paper estimates the effects of immigration on wages of native workers at the national U.S. level. Following Borjas (2003) we focus on national labor markets for workers of different skills and we enrich his methodology and refine previous estimates. We emphasize that a production function framework is needed to combine workers of different skills in order to evaluate the competition as well as cross-skill complementary effects of immigrants on wages. We also emphasize the importance (and estimate the value) of the elasticity of substitution between workers with at most a high school degree and those without one. Since the two groups turn out to be close substitutes, this strongly dilutes the effects of competition between immigrants and workers with no degree. We then estimate the substitutability between natives and immigrants and we find a small but significant degree of imperfect substitution which further decreases the competitive effect of immigrants. Finally, we account for the short run and long run adjustment of capital in response to immigration. Using our estimates and Census data we find that immigration (1990-2006) had small negative effects in the short run on native workers with no high school degree (-0.7%) and on average wages (-0.4%) while it had small positive effects on native workers with no high school degree (+0.3%) and on average native wages (+0.6%) in the long run. These results are perfectly in line with the estimated aggregate elasticities in the labor literature since Katz and Murphy (1992). We also find a wage effect of new immigrants on previous immigrants in the order of negative 6%.

Real-Time Assessment of the Economy

Ben Bernanke gave a speech today at a Boston Fed conference on inflation and the Phillip's curve. Part of the speech discusses the difficulties with real-time policymaking, and those remarks are repeated below. To complement the discussion, I also included an academic paper by S. Boragan Aruoba, Francis X. Diebold, and Chiara Scotti that develops "a framework for high-frequency business conditions assessment" that is an attempt to provide a solution to this problem. The paper is, essentially, a call to action on this problem and it attempts to lead the way by providing the methodology for obtaining real time assessments of economic conditions, and by providing an illustrative example (see the graph below). This is probably geekier than I realize:

Outstanding Issues in the Analysis of Inflation, by Ben S. Bernanke, FRB: ...Forecasting and controlling inflation are, of course, central to the process of making monetary policy. In this respect, policymakers are fortunate to be able to build on an intellectual foundation provided by extensive research and practical experience. Nonetheless, much remains to be learned about both inflation forecasting and inflation control. In the spirit of this conference, my remarks this evening will highlight some key areas where additional research could help to provide a still-firmer foundation for monetary policymaking.

...I will briefly touch on four topics of particular interest for policymakers:  commodity prices and inflation, the role of labor costs in the price-setting process, issues arising from the necessity of making policy in real time, and the determinants and effects of changes in inflation expectations. ...