The swamps of DSGE despair

David Andolfatto (of the St. Louis Fed and the blog MacroMania) points me to this interesting recent working paper by Braun, Korber, and Waki. The paper bears the somewhat unwieldy title of "Some unpleasant properties of log-linearized solutions when the nominal rate is zero."

Basically, the authors of this paper take a New Keynesian model somewhat similar to the ones used by "Keynesian" macroeconomists - e.g. Paul Krugman - to help justify the use of fiscal stimulus in a depressed economy. They note that in most papers, the models actually used to measure the effect of government policy are "linearized" versions. 

For the uninitiated: A DSGE model starts with the assumption of optimization by various economic agents such as households and firms, which spits out a system of nonlinear equations representing people's optimal choices. These nonlinear equations are then "log-linearized" around a "steady state", and the linearized forms of the equations, which are very easy to work with mathematically and computationally, are used to compute the "impulse responses" that tell you what the model says the effect of government policy will be. The linearization is equivalent to the assumption that the economy undergoes only small disturbances. That might not be a good assumption when it comes to major events like the recent crisis/depression, but it does make the models a LOT easier to work with. It also generally makes the equilibria unique - in other words, if you use the full, nonlinear version of a DSGE model, you are likely to come up with a bunch of different possible paths for the economy, and which path the economy takes will be determined purely by quantitative factors (like, whether variable X is more or less than 2.076, or something like that) - not the kind of thing that DSGE models are good at getting right. Since "multiple equilibria" generally means "we really don't know what's going to happen," macroeconomists tend to stick to the linearized versions of models, so that they can say "we do know what's going to happen."

Anyway, Braun et al. decide to venture into no-man's-land, and work with a non-linearized version of a New Keynesian model with a Zero Lower Bound. They find that, unsurprisingly, there are multiple equilibria. In some of these equilibria, the kind of special ZLB effects found by Eggertsson and Krugman - for example, the "paradox of toil" - are present, but small in size. In other equilibria, the effects go away entirely. 

So can we conclude that the concerns of Keynesian economists about the ZLB are overblown, and that fiscal policy isn't the answer? Not so fast. Here is another working paper, by Fernandez-Villaverde, Gordon, Guerron-Quintana, and Rubio-Ramirez, which conducts a similar exercise with a slightly different model. Fernandez-Villaverde et al.'s model is extremely hard to solve and their results come from picking some interesting-sounding cases and then doing numerical experiments (simulations) to see what happens in those cases. In the main case they consider interesting, the ZLB ends up being pretty important, and the fiscal policy multiplier is around 1.5 or 2.

(Update: A commenter points me to this response by Christiano and Eichenbaum, two of the leading New Keynesian theorists. They show that most of the multiple equilibria found by Braun, et al. are not supported by a specific model of learning. Also, here is a multiple-equilibrium DSGE paper by Mertens and Ravn showing that in some equilibria, fiscal policy actually makes recessions worse. The Mertens and Ravn result also conflicts with the learning model of Christiano and Eichenbaum.)

So what do we learn from these sorts of exercises? In my opinion, we learn relatively little about the real economy, but that's OK, since we do learn some important things about DSGE models. Namely:

1. Almost every DSGE result you see is the result of linearization, If you drop linearization, very funky stuff happens. In particular, equilibria become non-unique, and DSGE models don't give you a good idea of what will happen to the economy, even in the fictional world where the DSGE model's assumptions are largely correct! As Braun et al. write:

There is no simple characterization of when the loglinearization works well. Breakdowns can occur in regions of the parameter space that are very close to ones where the loglinear solution works. In fact, it is hard to draw any conclusions about when one can safely rely on loglinearized solutions in this setting without also solving the nonlinear model.

So even putting aside the question of whether DSGE models accurately represent reality, we see that most of the DSGE models you see don't even accurately represent themselves.

2. In order to be usable, DSGE models have to have a LOT of simplification. These nonlinear New Keynesian models go so haywire that they often have to be simulated instead of solved. Furthermore, neither of these models has capital or investment. Since investment is the component of GDP that swings most in recessions, you'd think this would be an important omission. But putting in capital would make these already mostly intractable models into utterly hopelessly intractable models (And if you don't believe me, ask Miles Kimball, who has spent considerable time and effort working on the problem of putting capital into New Keynesian models). Never mind putting in other realistic stuff like agent heterogeneity!

Basically, every time you model a phenomenon, you face a tradeoff between realism and tractability - the more realistic stuff you include, the harder it is to actually use your model. But DSGE models face an extremely unfavorable realism/tractability tradeoff. Adding even a dash of simple realistic stuff makes them get very clunky very fast.

3. DSGE models are highly sensitive to their assumptions. Look at the difference in the results between the Braun et al. paper and the Fernandez-Villaverde et al. paper. Those are pretty similar models! And yet the small differences generate vastly different conclusions about the usefulness of fiscal policy. Now realize that every year, macroeconomists produce a vast number of different DSGE models. Which of this vast array are we to use? How are we to choose from the near-infinite menu of very similar models, when small changes in the (obviously unrealistic) assumptions of the models will probably lead to vastly different conclusions? Not to mention the fact that an honest use of the full nonlinear versions of these models (which seems only appropriate in a major economic upheaval) wouldn't even give you definite conclusions, but instead would present you with a menu of multiple possible equilibria?

Imagine a huge supermarket isle a kilometer long, packed with a million different kinds of peanut butter. And imagine that all the peanut butter brands look very similar, with the differences relegated to the ingredients lists on the back, which are all things like "potassium benzoate". Now imagine that 85% of the peanut butter brands are actually poisonous, and that only a sophisticated understanding of the chemistry of things like potassium benzoate will allow you to tell which are good and which are poisonous. 

This scenario, I think, gives a good general description of the problem facing any policymaker who wants to take DSGE models at face value and use them to inform government policy.

So what's my suggestion? First I'd suggest detailed studies of consumer behavior, detailed studies of firm behavior, lab experiments, etc. - basically, huge amounts of serious careful empirical work - to find out which set of microfoundations are approximately true, so that we can focus only on a very narrow class of models, instead of just building dozens and dozens of highly different DSGE models and saying "Well, maybe things work this way!" Second, I'd suggest incorporating these reliable microeconomic insights into large-scale simulations (like the ones meteorolgists use to forecast the weather); in fact, any DSGE model that incorporates all of the actual frictions we find is likely to be so complicated, and so full of multiple equilibria in the full nonlinear case, that it demands this kind of approach. Third, and in parallel to the weather-forecasting effort, I'd echo Bob Solow's call to use simple models when trying to explain ideas to other economists and to the public (explanation of ideas being what DSGE models are mainly used for, given their abysmal performance at actually predicting anything about the economy). Note that I don't have a ton of confidence in these alternatives; after all, it's a lot easier to find flaws in the dominant paradigm than it is to come up with a new paradigm.

But in any case, few people in the macroeconomics field seem to be particularly interested in that sort of alternative approach, or any other. And the scientific culture of macroeconomics doesn't seem to demand that we find an alternative; in fact, in the macro profession, you pretty much have to back up any empirical result or simple model with a fully specified mainstream-ish DSGE model in order to be taken seriously.

So instead of trying to find which set of models really works, everyone just makes more models and more models and more models and more models...

(Note: If you know basic math and want to learn what DSGE models are all about, start with this chapter from David Romer's Advanced Macroeconomics.)

Update: Stephen Gordon agrees, and adds his own misgivings about DSGE.

The Iraq War: a cost-benefit analysis

Mark Steyn strikes me as the kind of guy who would trick his buddy into picking a fight, then laugh as his buddy got punched in the groin. In fact, that's pretty much typical of the people whom we have come to call "neocons" - bombastically blathering about empire and glory and destiny and national will from the safety of their manicured subdivisions while someone else's kid watches his intestines fall out of his abdominal cavity in some God-forsaken hellhole halfway around the globe. These are the sort of grinning fascists in whose minds democracy equals national weakness, and hence is a great thing to foist on our enemies while quietly suppressing at home.

OK, but that said, let's be economists about this. Let's do as Steyn purports (and in my opinion utterly fails) to do, and do a cold, calculating, rational cost-benefit analysis of the Iraq War.

This is very difficult to do, for two reasons. First, a counterfactual history is nearly impossible to construct; who knows how many of the things that have happened in connection with the Iraq War would have happened anyway, and who knows what other things would have happened? Second, the long-term effects of the war are not known; as with the French Revolution, it's "too early to tell" and always will be. But in these cases, you work with what you've got. So...

Costs of the Iraq War

* 150,000 - 200,000 Iraqis killed. This is a low estimate, but like many historians I tend to believe low estimates when it comes to war casualties, since there are a lot of refugees in wars, since government systems for counting people break down, and since a lot of people would have died anyway, especially given the crushing sanctions regime in place before the war. So let's make it 150-200k with an asterisk; it might have been three times that. (What's a factor of three between friends?)

* 4,400 Americans killed. Why list Americans separately from Iraqis (aren't they all humans)? Answer: Because many people care about this difference.

* 32,000 Americans wounded.  This could range from a cut on the arm to four lost limbs. Due to improved battlefield medicine, there are more of the very severe "four lost limb" type injuries now than in past wars.

* Hundreds of thousands of Iraqis wounded. Probably. I'm not sure anyone has been able to count this.

* About 6 trillion dollars of U.S. money spent (about 40% of one year of U.S. GDP)

* A moderate, permanent loss of American prestige in Europe (possibly inevitable due to the end of the Cold War).

* A large temporary loss of American prestige in Europe, reversed when the Obama administration came into power.

* A moderate, permanent loss of American prestige in the Islamic world, from an already low level.

* A solidifying of the Russia-China alliance, which looks very capable of containing American power globally. 

* A temporary distraction from the hunt for al Qaeda, reversed when Obama came into power and successfully killed al Qaeda's leadership.

* A long-lasting degradation of the quality of U.S. public discourse and the quality of U.S. politics. This item bears some explanation. In order to sell the war to the American people, large amounts of lying and distortion were necessary. Because of the stickiness of partisan opinions and worldviews (no one ever wants to admit their side was wrong), this meant that Republicans and conservatives had to retain that Bush-distorted worldview long after the war. That might be the reason why Tea Party types are up in arms about Benghazi, while the rest of America doesn't even know what Benghazi is. 

* An increase in geopolitical strength for Iran, commonly believed to be a strategic enemy of the U.S.

* An acceleration of Iran's nuclear program, seen by Iran as the only deterrent that can prevent a U.S. invasion.

* A high continuing rate of violence in Iraq.

Benefits of the Iraq War

* The removal of the Hussein family from power in Iraq, and their replacement with marginally less effective, malign, and insane dictators.

* The elimination of the tiny, tiny risk that Saddam would one day develop WMDs.

* An improved Iraqi economy. Iraq's GDP, which had been crushed by sanctions, after the war recovered strongly, growing robustly in every year since 2006. Part of this, of course, is a windfall due to high oil prices; but if the Iraq War hadn't happened, sanctions might have prevented Iraq from selling a lot of its oil.

* An Iraq that is slightly more free than under Saddam. Iraq is still rated "Not Free" by Freedom House, though its ratings have improved ever so slightly since the war. Freedom House is a U.S. government-sponsored NGO, so it's not a good idea to trust their data implicitly, but this seems to agree with many other reports. 

* A revitalized American liberal movement. The blogosphere as we know it really took off in response to the Iraq War, becoming the liberal answer to conservative talk radio. Truly liberal media outlets like MSNBC also emerged as answers to Fox News. And the general galvanization of America's dormant left might have enabled the election of Obama and sped the conservative retreat that we now see happening.

* The breaking of 9/11 fever. This is also hard to pin down, and may not even be real, but after 9/11 I felt a real sort of general madness in America. Terrorists could hit us any time, anywhere. The government was eliminating civil liberties right and left and people seemed to be fine with that. America seemed headed for a dark period of fear-based fascism, or Islamophobic ethnic conflict, or...well, something. Then the Iraq War came and brought more than half of America back to its senses. We remembered that the biggest threat to us is our own stupidity. We realized that the panic over a global jihadist wave was 99.9% paranoia. While the Republicans stayed nuts, the Democrats came back to the reality-based community.

Of course, these last two are a little silly to include as "benefits" of the war, since they weren't intended by the war's promoters (though neither were most of the costs). It's a bit like saying that the creation of the UN and the democratization of Europe were positive effects of Hitler's invasions, or that the worldwide condemnation of genocide was a positive result of the Holocaust. You should never start a war in the hope that you'll be defeated and that your defeat will invigorate the forces of good.

Anyway, so what do we conclude from this cost-benefit analysis? It's very hard to put dollar figures on these things, but I didn't try, because what this exercise should clearly demonstrate is that very, very little apparent benefit resulted from the decision to invade Iraq, while there were a whole lot of very apparent costs. This fact should dominate all discussions of the war. Who cares if we "won"? Who cares if the Surge (i.e. paying Sunni militias to stop bombing us, while pretending to make a show of force) worked? Who cares if Saddam was a brutal, awful guy? 

What should matter is that we paid a lot, and we got not much. There are a lot of two-bit dictatorships we could randomly invade and depose in bloody wars. There would be benefits to getting rid of Kim Jong-Un, or Robert Mugabe, or the mullahs of Iran. They just wouldn't be worth the price tag.

Markets in almost nothing

...Nothing important to human beings in rich countries, that is.

One of the first things I noticed when I started studying economics was that goods that can't be bought and sold are basically ignored. That might be fine for determining prices of stuff (especially if people have quasilinear utility), but when you have massively incomplete markets, the basic big results of first-year microeconomics - the welfare theorems - go totally out the window. In addition, to get comprehensible results for the prices and quantities of exchange-able goods, you need to make a lot of heroic assumptions about the non-exchange-able goods - in other words, when people spend most of their time working for things that money can't buy, their behavior toward the things that money can buy gets a lot more complicated.

And when I think about it, I realize that people do spend much of their time working for things that they can't possibly buy. Here are some examples of things that can't be purchased in any market, even with one hundred billion dollars or a million tons of gold:

* Love

* The respect of your peers

* A feeling of career "success"

* The ability to fit in with other human beings

* Close friends

* Your family being proud of how your life turned out

* The feeling of being good at what you do

* Dignity

There are many more examples. It's not a question of whether these things should or shouldn't be traded in markets. It's simply that they cannot be.

Now, of course you can purchase things that help you get the items listed above. You can buy a cell phone that will help you hang out with your friends or meet your lover for a date. You can buy a car that takes you to where your friends are, or where your job is. Etc. But markets won't get you all the way there. If you want a hamburger, in contrast, markets will get you all the way there - just slap down the cash and the burger is yours.

Also, some of you may be thinking "But, people who make more money get more respect and are seen as more successful!" And this is (often) true. But that's not the same thing as exchanging money for respect. Exchange is voluntary - I give you some good (or some financial asset, e.g. money, that represents claims to goods), and you give me some other good. But when you get respect for being rich, you are not giving up your money in order to get more respect. (Sometimes you can engage in conspicuous consumption, but that's a bit different.) So "money leads to respect" does not mean that there is a market for respect.

Others of you may be thinking "OK, well, some people are born with these non-exchange-able things. Those lucky people have higher baseline utility, but I don't see how this changes how markets work." Ah, but here's a key point: Many of these non-exchange-able goods can be produced. Good relationships, for example, are not something you are born with - they take time and effort to build. Similarly, the respect that comes with a successful career requires that you put a lot of work into the career.

So, basically, markets provide only a limited slice of the things that humans want. In fact, I'd argue that in rich countries in which food and security are not a problem for the majority of people, the vast bulk of our effort is spent producing non-exchange-able goods like "success", "respect", "love", and "relationships".

We live in a world of Massively Incomplete Markets.

What does this mean for economics? First of all, it may help explain a lot of the phenomena we see in markets. For example, a lot of people's "leisure" time is spent working at the production of (non-exchangeable) love and relationships; this could be the source of "consumption-leisure complementarites" and other phenomena that describe people's behavior toward work and leisure.

A second example: Though people in rich countries work a bit less than people in poor countries, the super-rich often work very hard (at least, the ones I know do). This is a puzzle for the type of simple utility functions used to explain labor-leisure choice in macroeconomic models. Why do the super-rich work? It could be because working itself provides them with utility, or it could be because working enables them to produce the feelings of self-worth and capability that their huge bank accounts can't possibly buy in any market.

A third example: People may choose to be unemployed for a very long time if the new jobs on offer represent a loss of "dignity" (due to, for example, their family or spouse seeing the new job as a "step down" in their career). This could lead to search frictions that might explain a lot of long-term unemployment. Dignity concerns also probably affect wage demands, which could lead to sticky real wages in addition to the more commonly used sticky nominal wages.

A fourth example: People notoriously like minimum wages better than government handouts like the EITC, even though most economists agree that the EITC is a lot more efficient. Why? Probably because "earned" income gives people a feeling of dignity, while "handouts" reduce dignity. The former can only produced through work, not bought in a market.

So I think that non-exchange-able, but producible, goods might have an absolutely enormous impact on economic behavior of all kinds. What gets exchanged in markets is heavily dependent on what must be produced outside of markets.

Also, I think that non-exchangeable producible goods should have an impact on our analysis of human welfare and government policy. Assuming that all consumption can be bought with money leads one to support policies like the EITC, but these policies may be extremely sub-optimal when goods like dignity are brought into the equation. Additionally, government should think about how its policies discourage the formation of human relationships - for example, by subsidizing low-density suburban sprawl that makes it hard to meet people.

Now, of course, in the most general sense, incomplete markets are a technological problem. After all, when the Beatles sang "Money can't buy me love," money couldn't even buy you hair. Someday we may get the ability to buy our emotions and desires from vendors. That will be a very weird day! But for now, Massively Incomplete Markets define our world.

(Note: I'm sure people have thought very long and hard about this already, but I don't know the literature, so feel free to recommend papers in the comments or on Twitter!)

John Taylor's austerity model

John Taylor, possibly more than any other economist who writes in the press, likes to simplify things for public consumption. Personally I think this is kind of a shame, since A) any WSJ reader who understands economic models will not understand what Taylor is talking about until they actually go read his research, and B) any WSJ reader who doesn't understand economic models probably already believes that "austerity = good", and doesn't really care if there's a DSGE model backing up the assertion.

Fortunately, your friendly neighborhood Noah is here to read and explain where Taylor is getting his arguments.

In today's column on austerity, Taylor writes:

This week the House of Representatives will vote on its Budget Committee plan, which would bring federal finances into balance by 2023. The plan would do so by gradually slowing the growth in federal spending without raising taxes. 

Still, the plan has been denounced by naysayers who assert that it would harm the economic recovery and that, at the least, any spending reductions should be put off until later. This thinking is just as wrong now as it was in the 1970s... 

According to our research, the spending restraint and balanced-budget parts of the House Budget Committee plan would boost the economy immediately. With the Budget Committee's proposed tax reform included, the immediate impact would be even larger... 

Our assessment is based on a modern macroeconomic model (developed with Volker Wieland of the University of Frankfurt and Maik Wolters of the University of Kiel)[.]

A modern macroeconomic model! Watch out, kid, you could put someone's eye out with that!

(Random note before we get started: The "1970s" reference is pure conservative herp-derpery. People weren't trying to fight stagflation with fiscal policy in the 70s; deficits were quite low. "The 70s" is just a word that conservative writers throw into their pieces so that conservative old men who read the article will nod their snowy heads in sage agreement and mumble "Yes, the 70s. Carter. Stagflation. Mmm-hmm!")

OK, but I digress. Why does Taylor think austerity will produce growth? The article doesn't tell us a lot about the aforementioned "modern macroeconomic model," so let's go to the source. Here it is. 

Taylor's paper basically uses a Smets-Wouters type DSGE model, i.e. the most popular and successful DSGE model in existence at the moment. It's a New Keynesian model, which means that demand shocks exist and have an effect, through sticky prices, and hence monetary policy matters. So it's not a "freshwater" or RBC-type model (though Taylor et al. do also show that their results hold with an RBC model, somewhat unsurprisingly). 

In other words, Taylor's model is not the type of model that many (including myself) have criticized for being too easily biased toward conservative policy conclusions. Instead, it is a very mainstream type of model, of the kind usually used to justify the Fed's role in managing aggregate demand. Of course, Taylor uses it for something quite different.

So anyway, I'm not going to copy the equations from the paper, because that would just bore you, and you can just read it yourself. However, I'll try to summarize. The upshot of the paper, as Taylor said in his WSJ piece, is that a certain kind of austerity plan would be good for the economy in both the long-run and the short-run.

Here are the basic things you should know about where Taylor gets his results:

1. This is NOT the "Treasury View." 

The "Treasury View" is the simplistic and wrong idea that any dollar spent on "stimulus" has to be one dollar not spent by the private sector, and hence government spending is incapable of raising output. Taylor is not espousing this view. In fact, as we'll see, in Taylor's model changes in government spending most definitely can affect output.

2. This is NOT the "Confidence Fairy."

The "Confidence Fairy" is the idea that uncertainty over future government policy restrains investment, and usually involves the notion that austerity decreases policy uncertainty. However, Taylor's model doesn't have policy uncertainty in it.

 3. The economic boost of austerity comes entirely from tax cuts.

Taylor's model has distortionary taxation in it, and the distortions are large. Hence, spending cuts mean lower taxes and hence less distortion, both now and in the future. In other words, the GDP boost in Taylor's model doesn't come from reducing the deficit, it comes from cutting taxes. The government's long-run budget constraint, along with forward-looking expectations (the same force that powers "Ricardian Equivalence" in other models), means that spending today --> taxes tomorrow --> distortions tomorrow --> distortions today because of forward-looking expectations.

4. The "Sumner Critique" is in this model. 

Normally, New Keynesian models of this type focus on finding the optimal monetary policy. But since Taylor is looking at fiscal policy, he assumes that monetary policy is set according to an unchanging rule.  OK, I'll put in ONE equation. Here's the rule:

This is a backward-looking Taylor rule with interest rate smoothing. Unfortunately, in this working paper I can't find what values Taylor uses for the coefficients on output and inflation. But he does put in some coefficients, that's for sure.

Remember, this is a New Keynesian model with sticky prices, so aggregate demand does matter. But Taylor assumes that the Fed is already doing pretty much everything a New Keynesian would have the Fed do.  So in Taylor's model, the Fed cancels out most aggregate demand shocks, including positive demand shocks from stimulus. So it's hardly surprising that Taylor is not going to see government spending doing much good for the economy; he's assumed that 1) the Fed is perfectly capable of managing aggregate demand, and 2) the Fed will tighten to partially counteract stimulus. This is just a softer version of the common "Sumner Critique" of fiscal policy, though of course Taylor probably didn't get it from Sumner.

5. There is no Zero Lower Bound.

Note that in the monetary policy rule written above, there is nothing that says that interest rates can't go negative. In other words, Taylor assumes what most New Keynesian models assume, which is that there is no Zero Lower Bound (or that we're always far from it). Any of you who are familiar with the New Keynesian DSGE literature will recognize that Taylor's result is a very common result in this literature: Away from the ZLB, fiscal policy is not very effective. The "New Old Keynesians" such as Paul Krugman and Gauti Eggertsson, who advocate fiscal stimulus, explicitly make reference to the ZLB as the reason stimulus works. Taylor just ignores that idea in this paper.

6. In Taylor's model, if you cut government purchases, it throws the economy into a recession.

Taylor's suggested austerity plan makes big spending cuts, but the cuts are almost entirely cuts in transfers (like entitlement payments or welfare) rather than in government purchases (like infrastructure spending). Here's a picture of Taylor's austerity plan:

Now as you should remember from Econ 102, government purchases make much more effective stimulus than transfers, because government doesn't buy the same things that people would buy if you just mailed them checks (but people still receive the checks). So any Keynesian would expect cuts in transfers to be much more benign than cuts in government purchases. In fact, the difference between purchases and transfers is a consistent theme in Taylor's work, which makes me think he's more Keynesian than he makes himself out to be. But anyway, let's take a look at what Taylor's model says would happen if we implemented austerity through reductions in government purchases instead of cuts in transfers:

Wow! In Taylor's model, implementing austerity by cutting government purchases would throw the economy into a deep recession. The reason he gets short-run benefits from spending cuts has everything to do with the fact that it's almost all transfers being cut.

6. In sum, Taylor's result is a standard New Keynesian result.

Upshot: If you have no Zero Lower Bound, and if the Fed partially counteracts the demand-side effects of fiscal policy, and if people have forward-looking expectations, and if you don't cut government purchases much, and if taxes are very distortionary, then austerity works. This is not really a new result, but it rarely gets shown so explicitly, so it's good that John Taylor and his co-authors went ahead and did it.

That said, the result basically ignores the real Keynesian critique that has emerged since 2008, which is that the Zero Lower Bound matters a lot. It also probably assumes that taxes are a bit more distortionary than they really are. And it also probably overestimates the Republicans' real willingness to cut transfers (entitlements are the "third rail", after all), and underestimates their willingness to cut government purchases. In real life, spending cuts usually fall on the things that are politically most easy to cut, but are economically most valuable in both the short and long runs - infrastructure and research. Finally, Taylor's plan ignores distributional concerns, but that's pretty much par for the course.

(Oh, also, neither Taylor's model nor the RBC or Keynesian alternatives includes nonrival government capital (public goods). But that's not the point I'm trying to make here. Oh, and also, modern macroeconomic models - and any other macroeconomic models currently in existence - don't actually come close to describing reality. But that's also not the point I'm trying to make here.)

So John Taylor is not committing some major fallacy. He's just using a standard mainstream New Keynesian DSGE model to stump for the Republicans.


Update: Miles Kimball says that Taylor's result is basically all about the monetary policy reaction function (i.e. the equation I posted above). Furthermore, Kimball notes that Taylor has supported a tighter monetary policy, in direct opposition to the kind of Fed reaction function he assumes in the paper. In other words, if Taylor got the monetary policy he wants, then his own DSGE model would go *poof* and suddenly austerity of the transfer-cutting type would become much more harmful.

Update 2: A commenter points out that in Taylor's simulations, real interest rates never fall below zero. That means there's something odd about the parametrization, since real short rates are negative right now. But I don't know where the oddness comes from.

Labor Department Pick Signals New Concern for Self-Insurance Industry

The announcement today that President Obama has nominated Tom Perez as the next Secretary of Labor arguably sets the stage for a strong federal push to restrict the ability of thousands of employers nationwide from sponsoring self-insured group health plans.

This provocative conclusion requires the connection of several dots, so we’ll lay them out for your consideration.

As this blog has reported previously, federal regulators have been asking lots of questions about self-insured group plans since the passage of the ACA.  More specifically, they are trying to determine whether smaller self-insured employers that purchase stop-loss insurance with “low” attachment points constitute a “loophole” to the health care law and that these employers are somehow “gaming” the system.

We’ve methodically discredited these assertions multiple times, but it’s important to set the stage as new developments are reported and additional context is provided.

Since insurance is largely regulated at the state level, the obvious question arises regarding how the feds can regulate stop-loss insurance should they wish to do so?  This can clearly be done through federal legislation or potentially through regulation. 

The regulatory route is more complicated as the ACA does not provide any explicit statutory authority for such action.  But regulators can be a creative bunch, especially under the current Administration.

The creative theory is that federal agencies with jurisdiction over the Public Health Services Act (PHSA) and the Employee Retirement Income Security Act (ERISA) may rely on the their general rule-making authority given to them under their respective laws to argue that the federal government may indeed need to regulate stop-loss insurance and re-characterize stop-loss policies with “low” attachment points as “health insurance” through regulations separate and apart from the new law. 

While this action would be controversial and subject to challenge by Congress and private citizens, it is possible that a rule-making process could be initiated to achieve this policy objective.

Based on discussion with key regulators as recently as last week, such a rule-making process is unlikely to occur this year.  This blog speculates that the primary consideration for inaction at this point is that regulators are simply overwhelmed with finalizing all of the rules and related guidance required for full ACA implementation at the end of this year.

Once these deadlines pass, however, the regulators will have more bandwidth to circle back on ancillary areas of interest.  Here’s where we connect the dot with Mr. Perez’ name on it.

While the career professional staffers within DOL (non-political appointees) are competent and at least reasonably objective in most cases, the new agency head is anything but.

Mr. Perez comes with baggage from his tenure within the Justin Department where evidence strongly suggests that at least some of his civil rights enforcement decisions were influenced by political considerations.   In short, he a “social justice” guy who fits nicely into the Administration’s template for policy-making.

His resume also includes a stint with HHS under the Clinton Administration and a senior staff position with the late Senator Ted Kennedy.  Rounding out his big government pedigree, he is a graduate of Harvard Law School and the George Washington Public School of Health.

All of this background suggests that Mr. Perez will be inclined to position DOL as a more activist agency with regard to health care reform issues, including stop-loss insurance regulation.   This motivation will likely be particularly acute if the SHOP exchanges run into early problems with lack of enrollment as many experts predict.

For the sake of discussion, let’s assume this analysis is correct.  In this case, then Secretary Perez could push for a rule-making process as described earlier, or perhaps lead an effort to close the self-insurance “loophole” through federal legislation.  Let’s connect another dot.

As a technical matter this would a “cleaner” approach and not subject to legal challenge.   Congress could simply enact legislation amending the definition of “health insurance” under the PHSA, ERISA and the Code to include, for example stop-loss policies with a “low” attachment point.

Given that Republicans control the House right now and are generally supportive of self-insurance, the politics do not support this potential strategy.   But if you believe recent public commentaries that the Administration’s grand political plan is focused on the objective of Democrats winning back control of the House in 2014, the legislative pathway becomes clearer. 

Und this scenario, it’s hard to imagine that a Secretary Perez would not push for a legislative “fix.”  After all, it’s not fair that some citizens are saved from the exchanges in favor of receiving quality health benefits from their employers, right?   Social justice, indeed. 

And the last dot is connected.

 

 

The Coming Crossroads for LRRA Legislation

It’s been a while since we’ve reported on efforts to modernize the Liability Risk Retention Act through federal legislation, but there may be some new developments this spring worth discussing.

A key congressional source confirmed today that draft legislation is currently being vetted in the House prior to potential introduction in the next month or two.  While previous versions of the bill included a federal arbitration provision to address situations where non-domiciliary regulators take actions against RRGs operating in their state that should be preempted by the LRRA, this provision will not be included in this year’s bill if it introduced.

This is largely a political consideration, as the chairman of the House Financial Services is extremely sensitive about any legislation that can be viewed as expanding the role of the federal government in the regulation of insurance.   This blog takes the contrary view in that such a provision actually strengthens the home state regulator, but the politics are what they are.

With the arbitration provision stripped out, the main focus of the bill will be to allow RRGs to write commercial property coverage.  In anticipation of this expected development, several captive insurance leaders were polled to take their temperature on the relative importance of such a change to the LRRA.

The feedback was mixed evidenced by the sampling of responses as follows:

On The One Hand….

“I think ART as an industry needs as many tools as possible in the toolbox and any victory we can get, however small, is a step in the right direction.”

“I would like to see this pass because people keep thinking this only expands to commercial property – not so – it would allow auto physical damage.”

On the Other Hand….

“I’m of the opinion that RRGs time as a viable ART risk funding mechanism is waning.  I say this because of the NAIC’s accelerating aggressiveness in its attempt to impose governance standards on RRG domiciliary states equal to or greater than those imposed on traditional insurance companies.”

“Even with reinsurance backing the level of property risk undertaken by an RRG is not likely to create the beneficial impact for RRG members compared to the liability segment.”

 

So for an industry that can be apathetic when it comes to federal legislative/regulatory developments, even when everyone is in agreement, it will be interesting to see if any meaningful support materializes if/when LRRA legislation version 2.0 is introduced given differing opinions on the relative importance.

Given that the probability of a 3.0 version anytime in the foreseeable future is close to zero, get ready for the crossroads.

 

How the poor can (and should!) save money

Although my Atlantic column on wealth inequality got a lot of publicity, the comments were mostly negative. Almost all of them said one basic thing: "The poor don't have any money to save!"

Now, first of all, this means that a lot of people just glossed over the column itself, and instead just guessed/assumed the message from the title and picture. These people assumed that my column was calling for the poor and middle class to help themselves instead of relying on society to help them (in other words, basically an "angry conservative uncle" column). Whereas if they read it closely, they'd find me saying this:

[O]ne obvious thing we could do to make wealth more equal is - surprise! - redistribution. It turns out that income redistribution and wealth redistribution have much the same effect on the wealth of the poor and middle-class. Income redistribution is probably a bit better, for two reasons. First, people with higher incomes tend to save more, meaning they build wealth more rapidly. Second, people with higher incomes tend to have less risk aversion, meaning they are more willing to invest in assets like stocks (which get high average rates of return, although they are risky) rather than safe assets like savings accounts and CDs that get low rates of return. 

In other words, giving the poor and middle-class more income will boost the amount they are able to save, the percentage they are willing to save, and the return they get on those savings. Part of the reason America's wealth distribution is so unequal in the first place is that our income distribution is very unequal.

So obviously I do realize that the poor have very little money; this is why I suggest that we tax the rich to give the poor more money, in order that they may save more (and consume more, of course)!

But it's also true that if we mail checks to poor people, they will still have to save part of those checks if they want to build wealth. 

Now here's where we come to the question of how, exactly, the poor can save money. Saving is not all about belt-tightening and going hungry. In fact, for the poor, it's mostly not about that at all! For the poor, the most important way to save is to avoid taking out high-interest debt. 

Remember, saving and borrowing are exact opposites! A dollar not borrowed from a payday loan or credit card is a dollar saved.

Take the case of payday loans. This is one case in which I think it's fairly obvious that debt is used to extract wealth from the poor. Payday lenders exploit poor people's ignorance and behavioral biases to trick them into taking out loans that they don't need to take out. 

To see this, go and read the recent Pew report on payday lending. Some of their most important findings are:

1. Most payday loans get paid back within a year. Since payday loans charge insane rates of interest (thousands of percent!), this represents a substantial loss to poor people.

2. Most payday loans are taken out to cover regular expenses (bills, etc.), not emergencies. 

3. If they couldn't use payday loans, most borrowers would either cut back on expenses or borrow from family and friends.

4. Payday loan borrowers typically repay their loans by...cutting back on expenses and borrowing from family and friends!

In other words, combining these findings, we see one simple truth: Most poor people, if they didn't take out payday loans, would not die. They would not be out on the street or crippled or starving. Instead, they would simply be wealthier. For this reason, many states, and the federal government, are all actively looking into legal restrictions on payday lending; some have already done this.

Regulation can help, but tricksters are ingenious. Poor people need to learn how to avoid the tricksters. My column was suggesting that government, through public school and through awareness campaigns, can help people avoid the tricksters just as fast as the tricksters can come up with new tricks. 

And this probably applies to middle class people as well, who almost certainly borrow way too much on credit cards. 22.5% interest?? You have to be kidding me! The whole credit card industry survives only because of the large number of people who make only their minimum payments and end up getting trapped in high-interest credit card debt for life. Some of those people borrow for emergency medical expenses, but even in those cases - where borrowing makes sense - I'm sure people could find much cheaper ways to borrow.

The point is, avoiding unnecessary high-interest debt is equivalent to saving lots and lots of money, while consuming the same amount overall. In other words, it;s a free lunch for people, as long as they known how to grab it.

Anyway, I think a lot of people saw my column as an "either/or" thing - they thought I was arguing that we should encourage self-reliance and ignore the social aspect of wealth inequality. But I don't see these things as substitutes. I see them as complements. We want society to help the poor and middle-class as much as possible. And we also want the poor and middle-class to help themselves as much as possible. That way, the poor and middle-class get the maximum amount of total help possible. There is no trade-off!

And remember, if you live in a corrupt, predatory kleptocracy, you want to A) fight to change your society for the better, and B) at the same time, rely as little as possible on the goodwill of the corrupt kleptocracy to provide you with your daily bread. "Just save your money" is not a cure-all for the poor. But "save your money while fighting to change the system" is way better advice better than "spend all your money and borrow at 3000% and pray for the revolution to come soon".

Atlantic column: Building the wealth of the poor and middle class

New column up at The Atlantic. The basic idea: We should try to make Americans' wealth distribution more equal. Excerpts:

The math of wealth is actually pretty simple: It all boils down to four things: 1. How much you start with, 2. How much income you make, 3. How much of your income you save, and 4. How good of a rate of return you get on your savings...

So one obvious thing we could do to make wealth more equal is - surprise! - redistribution...giving the poor and middle-class more income will boost the amount they are able to save, the percentage they are willing to save, and the return they get on those savings. Part of the reason America's wealth distribution is so unequal in the first place is that our income distribution is very unequal... 

[But] the most potent way to get more wealth to the poor and middle-class is to get these people to save more of their income, and to invest in assets with higher average rates of return... "Cheap" is an insult, but being cheap is how you get rich... 

 For years, behavioral economists such as Richard Thaler have been studying ways to "nudge" people to save more...This means that more financial education in public schools is a must. I'm not talking about teaching kids the Capital Asset Pricing Model. I mean what Bob Shiller calls "basic Suze Orman stuff." How to make a monthly budget. What "saving" and "borrowing" mean. How wealth builds over time. How to avoid borrowing lots of money at high interest rates (e.g. credit cards and payday loans). Etc. The new Consumer Financial Protection Bureau can help a lot with this too, by preventing companies from tricking poor people into taking out high-interest debt... 

In addition to "nudging" middle-class and poor Americans to save more, we can help them get a better return on their assets -- the second thing that has a huge effect on wealth in the long run. This means helping middle-class people invest in stocks without paying high fees. The first part of this is teaching middle-class people to avoid making frequent changes in their stock portfolios... 

The second way to get better returns is to avoid actively managed funds. Actively managed mutual funds charge high fees to purchase portfolios of stocks that, statistically, are no better than simply buying a low-cost "index" fund that tracks the overall level of the market. Pension plans like TIAA-CREF tend to charge even higher fees, meaning even worse returns. Financial education can teach middle-class people what a low-cost index fund is, and how to invest in one.

Read the whole thing here!

The Left and wages

Matt Yglesias has a post about the left and wages that I think makes a number of errors. Here's the intro:

The left is rightly concerned about the real wages and incomes of ordinary working people. But the left fallaciously analogizes from a bargaining dynamic at a single firm to the entire economy.

Well, I think many people do make errors of this type ("The government is like a household" being the most common). But I don't think that the Left is doing this when it comes to wages. Let's see what Matt thinks the Left is doing. He continues:

The way a given worker or class of workers improves his real wages is by persuading his boss to give him a nominal raise that outpaces the growth in the cost of living. But the way the economy as a whole works is that my income is your cost of living. If Slate doubled my salary, I'd be thrilled. But if everyone's boss doubled everyone's salary starting on Monday, we'd just have one-off inflation. As it happens, a little inflation would do the macroeconomy some good at the moment. But the point still holds that while "you get a raise" is the way to raise your living standards, "everyone gets a raise" is not the way to raise everyone's living standards.

The first error I see here is the idea that wages = incomes. Only about 55% of Americans' income comes from "labor". The rest comes from "capital" - land rents, corporate profits, and interest income. It is true that the sum of all expenditures across an economy equals the sum of all incomes. It is not true that the sum of all expenditures across an economy equals the sum of all wages. Thus, it is possible to raise every wage-earner's wage at the same time. This would simply result in an increase in labor's share of national real income, and a decrease in the share allocated to capital. In other words, it would be the exact reverse of what has happened to our economy since (at least) 2001:



The second error I think Matt makes is that he talks about the mean, while the Left generally cares about the median (or some lower percentile). It is possible for median real wages to increase even while mean real wages stay flat. This would mean a more equal distribution of income...in other words, the reverse of what has happened over the past three decades:



(Source: The Atlantic)

Matt goes on:

To raise real wages across the economy...what you need to do is make things cheaper. And that generally entails an accumulated series of events that make selected groups of people's nominal incomes lower. If everyone could be chauffered around cheaply by autonomous cars, then the people who currently earn a living driving cabs and buses and trucks will lose out. If computers take over routine diagnostic work, then doctors will lose out. If online courses that serve tens of thousands of students displace community colleges, then community college instructors will lose out.

This is just not right. The process that Matt describes need not reduce nominal incomes. Suppose, first of all, that everyone had to stay in the same line of work forever (which is not true, but which is a necessary assumption if you want to use phrases like "cab drivers will lose out"). Now an industry-specific productivity shock comes along - someone invents a latte machine that makes better-tasting lattes, twice as fast, while using only half the milk. The real price (i.e. the relative price) of lattes will fall. The quantity of lattes sold will rise. The income of latte-makers (the # of whom, remember, is fixed!) equals the price of lattes sold multiplied by the quantity of lattes sold.

Will this income go up or down? Well, you can see for yourself, with a bit of Econ 101. Draw a supply-demand graph for the latte market. Model the productivity improvement as a rightward shift in the supply curve. Take the derivative of equilibrium income with respect to some level parameter of the supply curve. You will find that whether latte-makers' incomes go up or down depends on the elasticities of demand and supply for lattes. In particular, if demand for lattes is very elastic, then the incomes of latte-makers will go up. (This result will also hold in general equilibrium.)

Now, those are real incomes, and Matt did say "nominal". But if the latte market is small compared to the overall market - in other words, if the change in the price of lattes is not enough to change the aggregate price level much - then real and nominal are approximately equal. So it's easily possible for latte-makers' nominal incomes to go up when their productivity improves, even if latte-makers are unable to shift to other jobs.

(Note that "latte-makers' incomes" includes the wages of latte-making workers and the capital income of latte-making firms. Who pockets more of the increase depends on other stuff, including workers' bargaining power.)

So I see Matt making some econ mistakes here. But anyway, what is the takeaway? Well, it's not clear what Matt thinks the Left is trying to do at the national level. If he sees the Left as a bunch of Luddites, trying to block the implementation of new technology, then his case would be strengthened by the points I made above.

But I do not see the Left as a bunch of Luddites. I see them as trying to increase the bargaining power of workers relative to capital owners, by any means available. That rarely involves Luddism; in fact, I can't really recall seeing any American Leftist types trying to block the spread of new technology. On the contrary, labor advocates like Dean Baker routinely trumpet advances in productivity; rather than trying to halt these advances, they decry the fact that too much of the surplus from the advances is flowing to owners rather than workers.

So I guess I don't see what specific mistaken thing Matt thinks the Left is actually doing.

Now this is a bit beside the point, but I personally do see the Left making some mistakes. I think the Left probably tends to overstate the effect of politics (e.g. union-friendly laws) relative to structural changes (especially globalization) in eroding workers' power. I think they often overestimate the degree to which American trade policies can affect the process of globalization. And I think they see immigration as more of a threat to native-born workers than it really is.

But I don't think any of these things has to do with a mistaken analogy between a single firm and the entire nation. The Left wants to increase labor's share of income, and decrease the skewness of the wage distribution. How to do that is an open question, but those goals seem perfectly reasonable to me.

How is Abenomics doing?

Last December, Shinzo Abe swept to power, promising to force the Bank of Japan to re-inflate the economy at any cost, boost stimulus spending, and (maybe) join the Trans-Pacific Partnership. By far the most striking of these pledges was the first one. A number of monetarist-leaning academics I talked to expressed great hope that "Abenomics" would revitalize the Japanese economy. This sentiment was echoed in the press by monetarist-leaning pundits such as Matt Yglesias, Joe Weisenthal, and some of me colleagues (can I say "colleagues" without being full-time staff?) at The Atlantic. "Market monetarists" were more circumspect - after all, to them, anything other than NGDP targeting is no true monetarism - but Scott Sumner did cite the recent Japanese stock market rally as proof that expectations-based monetary policy is effective at the Zero Lower Bound. Even those who were less eager to jump on the Abenomics bandwagon said that Abe's revocation of central bank independence and determined efforts to whip deflation would constitute an important experiment in monetary policy.

So how is Abenomics doing?

Well, on the plus side, there have been two pronounced effects. The first is the aforementioned stock market rally. Here is the Topix (similar to our S&P) over the last 3 months:

And here is the yen/dollar over the same period (higher means weaker yen):

So as you can see, Abe's election has sparked a rapid depreciation of the yen (which should, theoretically, boost Japan's exports), and a rally in the Japanese stock market.

So that's the good news. Here's the bad. Since Abe's election, Japan has slipped back into deflation:

But inflation expectations, as measured by breakevens on the Japanese version of TIPS, are up - to 1%. So maybe we'll see this deflation turn around soon.

As for Japan's current account, it has continued to log a deficit, as the weak yen made imports more expensive. As for whether or not export demand will pick up...I guess we'll see. Capital expenditures by Japanese firms were still falling in December, but we'll just have to wait for more recent data.

In summary: Abe seems to have shifted a lot of people's expectations. He seems to have convinced many foreigners that Japan will print a lot of money; this has caused a fall in the yen. And those expectations of a falling yen seem to have convinced many foreigners that the weaker yen will boost the profits of Japanese companies, since foreign investors are behind Japan's stock market rally. And he has also convinced some Japanese people that deflation will soon give way to weak inflation...though these expectations have not yet translated into real inflation.

But now comes the real test. Convincing foreigners that big changes are coming to Japan is an easy trick, but it won't help Japan's economy a lot. The shift to 1% inflation expectations is more promising. But 1% is still pretty darn low.

Yet I still stand by my initial evaluation - Abe is generating a brief fillip of optimism and a sense of economic movement in order to secure an LDP majority in the all-important upcoming upper house election. Securing that majority would allow him to get on with his true all-consuming priority - revising Japan's constitution. After that, his conservative instincts, and the conservative instincts of the Finance Ministry (which is arguably a lot more powerful than the Prime Minister), will take over, as will the worries of the LDP's elderly voters that inflation would destroy their hard-earned life's savings. At that point, talk of radical monetary reform will evaporate, and the recent movements in the yen and the Japanese stock market will begin to slowly unwind.

This is a pessimistic scenario, but, like Japanese consumers' expectations of deflation, my beliefs about the effectiveness of Japan's Liberal Democratic Party are strongly anchored, and will require more than a bit of tough talk to dislodge.

Rough Notes Teen Driving Video

Having a child that is just starting to drive can be very stressful.  As  a parent you will worry about them everytime they step into the driver's side of a car.  The only thing you can do, though, is to educate your new driver as best you can.  Rough Notes created an educational video for new drivers.  It focus on insurance but also talks about being responsible.  This is a great video to show new drivers. 

Fancy stimulus tools: policy vs. politics

On 2/26, Miles Kimball wrote a Quartz column called "What Paul Krugman got wrong about Italy's economy", in which he said this:

In the last few days, while the US political debate centers on ways to deal with burgeoning debt, UK government debt has been downgraded and investors are demanding much higher yields on Italian debt in the wake of the Italian election results (paywall). As concerns about national credit ratings push economies around the world toward austerity–government spending cuts and tax hikes–some commentators are still calling for economic stimulus at any cost. Joe Weisenthal wrote that David Cameron must spend more money in order to save the British economy. Paul Krugman wrote in “Austerity, Italian Style” that austerity policies simply don’t work. The downside of their prescription of more spending—and perhaps lower taxes—is that it would add to the United Kingdom’s and to Italy’s national debt. And national debt beyond a certain point can be very costly in terms of economic growth, as renowned economists Carmen Reinhart, Vincent Reinhart, and Kenneth Rogoff convincingly show in their National Bureau of Economic Research Working Paper “Debt Overhangs, Past and Present.” 

Where do the United Kingdom and Italy stand in relation to the 90% debt to GDP ratio Reinhart, Reinhart and Rogoff identify as a threshold for trouble? (It is important to realize that their 90% threshold is in terms of gross government debt. That is, it does not net out holdings by other government agencies.)

Paul Krugman responded thus:

[T]o my great disappointment all I found was yet another invocation of the Reinhart-Rogoff claim that bad things happen when debt goes about 90 percent of GDP.

Look, this is just not an established result. It’s a correlation; but it could just as well reflect a pathway from slow growth to high debt, or from third factors like political and institutional dysfunction to both slow growth and high debt...

So why do people imagine that this is a definitive result? That’s obvious. R-R on debt got picked up eagerly by deficit scolds, because it said what they wanted to hear...

Is Reinhart-Rogoff itself a zombie? Not quite — it could still be true, although I don’t think so. But the idea that the 90 percent threshold is a definite result, established beyond question, is very much a zombie idea, one that has been killed repeatedly but just won’t stay down.
So who is right?

Krugman has a good point: The "90%" thing is not well established; it is obviously just Reinhart and Rogoff eyeballing some sparse uncontrolled cross-country data and throwing out an off-the-cuff figure that got big play precisely because it was simple and (to deficit scolds) appealing. The 90% number alone is not a justification for worrying about debt.

However, Krugman did fail to notice one interesting point. When discussing a paper by Greenlaw et al. (which makes an "80%" claim similar to R&R's "90%" claim) in an earlier post, he noted a very interesting pattern:

Even the quickest look at the data suggests that there’s something to this argument; for example, taking data from the paper itself, and dividing the countries into euro and non-euro, we get a scatterplot like this: 

 

It’s not just Japan, off at the far right, that looks different; Canada, the UK and the US, the three red squares along the middle bottom, also seem to have borrowing costs well below what euro-area experience might have suggested. 

Furthermore, the experience since mid-2012, in which the ECB drove spreads down sharply after it signaled its willingness to head off self-fulfilling liquidity crises — which can’t happen to countries with their own currencies – also suggests that the own-currency issue is crucial.

So we have a good theoretical reason to believe that eurozone countries - which don't have their own currencies - are very different animals from countries like the U.S. and UK. In other words, there probably is a good reason to worry about Italy's debt levels.

Of course, Miles misses this too, and lumps own-country borrowers in with eurozone borrowers.

But I feel that this argument over debt levels is mostly a distraction. The important thing, which is being overlooked, is that Miles has come up with a really interesting policy tool to increase the amount of stimulus per unit of debt incurred. That tool is Federal Lines of Credit, or FLOCs - basically, the idea that government should lend people money directly.

FLOCs have a distinct advantage. They avoid the problem - which everyone acknowledges - that people tend to pocket and save their stimulus checks, thus canceling out the effect of the stimulus while running up government debt. FLOCs only dish out money if people are going to spend it; hence, they get more stimulus "bang" for every debt "buck". Even if we aren't worried about debt at all, FLOCs seem like a good deal, compared to just mailing out checks.

However, I do have some skepticism about FLOCs. First of all, there is the idea that much of the "deleveraging" we see in "balance sheet recessions" may be due to behavioral effects, not to rational responses to a debt-deflation situation. People may just switch between "borrow mode" and "save mode". In that case, offering them the chance to take on extra debt is not going to do much. Second, and more importantly, I worry that FLOCs might draw money away from infrastructure spending and other government investment, which I think is an even more potent method of stimulus; govt. investment, like FLOC money, is guaranteed to be spent at least once, but unlike FLOCs it can increase public good provision, which is a supply-side benefit.

(Note: Mike Konczal has addressed Miles' proposal, and has a lot of problems with it.)

That said, I think the FLOC idea is an interesting one. Why have most stimulus advocates ignored it? My guess is that this is about politics. In an ideal world, pure technocrats (like Miles) would advise politicians in an honest, forthright fashion as to what was best for the country, and the politicians would take the technocrats' advice. In the real world, it rarely works that way. For every technocrat who just wants to increase efficiency, there's a hundred hacks and politicos who are only thinking about distributional issues - grabbing a bigger slice of the pie. These hacks are very willing to use oversimplified narratives and dubious sound bytes to embed their ideas in the public mind. And that kind of thing really seems to be effective.

This means that politics' response to policy is highly nonlinear - give the enemy an inch, and they take a mile. It also means the response is highly path-dependent; precedent matters.

So Krugman et al. may be ignoring FLOCs and other stimulus engineering tricks because of political concerns. If they concede for a moment that debt is scary, it will just shift the Overton Window toward Republican types who are deeply opposed to any sort of stimulus, and would oppose Miles' FLOCs just as lustily as they opposed the ARRA.

In other words, finding optimal, first-best technocratic solutions might be far less important than simply embedding "AUSTERITY = BAD!!!" in the public consciousness.

Blogger smackdown: Robert Waldmann vs. David Glasner

Somehow I missed the first few salvos in this little police action, but I'm on it now! In this corner, we have Robert Waldmann, one of the pioneers of "noise trader" finance theory. In the other corner we have David Glasner of the FTC. Today's ingredient is wild mushrooms question is whether monetary policy works.

(I have to say, it's pretty fun to see these two guys debate, since Waldmann is one of the most terse bloggers out there, and Glasner one of the most verbose.)

Waldmann starts with a potshot at Matt Yglesias' rosy predictions for Shinzo Abe's monetary policy:

Ben Bernanke too has declared a policy of unlimited quantitative easing and increased inflation (new target only 2.5% but that's higher than current inflation).  The declaration (which was a surprise) had essentially no effect on prices for medium term treasuries, TIPS or the breakeven....[Y]ou have confidently asserted again and again that if only the FOMC did what it just did, expected inflation would jump and then GDP growth would increase. However, instead of noting the utter total failure of your past predictions (and the perfect confirmation of mine) you just boldly make new predictions. Face fact,  like conventional monetary policy (in the US the Federal Funds rate) forward guidance is pedal to the metal. It's long past time for you to start climbing down. 

Basically: "QE-infinity didn't budge inflation expectations, so monetary policy doesn't look like it works the way monetarists say it should work."

Glasner then jumps in to say, well, the Fed hasn't really done very much in terms of changing policy:

I mention this, because just yesterday I happened across another blog post about what Bernanke said after the FOMC meeting.  [That] post by David Altig, executive VP and research director of the Atlanta Fed, was on the macroblog. Altig points out that, despite the increase in the Fed’s inflation threshold from 2 to 2.5%, the Fed increased neither its inflation target (still 2%) nor its inflation forecast (still under 2%). All that the Fed did was to say that it won’t immediately slam on the brakes if inflation rises above 2% provided that unemployment is greater than 6.5% and inflation is less than 2.5%. That seems like a pretty marginal change in policy to me.

Waldmann then responds with two points. First, he criticizes Glasner for failing to mention the Zero Lower Bound: 

Your analysis of monetary expansion does not distinguish between the cases when the ZLB holds and when it doesn't...I think it is clear that the association between the money supply and domestic demand has been different in the USA since oh September 2008 than it was before...

Second, he says that the data show no indication of Fed policy announcements having any effect:

I claim that the null that nothing special happened the day QEIV was announced or any of the 4 plausible dates of announcement of QE2 (starting with a FOMC meeting, then Bernanke's Jackson Hole speech then 2 more) can't be rejected by the data. This is based on analysis by two SF FED economists who look at the sum of changes over three of the days (not including the Jackson Hole day when the sign was wrong) and get a change (of the sign they want) whose square is less than 6 times the variance of daily changes (of the 10 year rate IIRC).  IIRC 4.5 times.  Cherry picking and not rejecting the null one wants to reject is a sign that one's favored (alternative) hypothesis is not strongly supported by the data.

Basically: "We shouldn't assume that monetary policy works at the ZLB. We should assume it doesn't work at the ZLB, unless we have clear evidence that it does. We haven't seen any clear evidence that monetary policy works at the ZLB, so we should continue to assume it doesn't."

Glasner responds first by throwing out some of his own ideas about how monetary policy should work:

I agree that the zero lower bound is relevant to the analysis of the current situation. I prefer to couch the analysis in terms of the Fisher equation making use of the equilibrium condition that the nominal rate of interest must equal the real rate plus expected inflation. If the expected rate of deflation is greater than the real rate, equilibrium is impossible and the result is a crash of asset prices, which is what happened in 2008. But as long as the real rate of interest is negative (presumably because of pessimistic entrepreneurial expectations), the rate of inflation has to be sufficiently above real rate of interest for nominal rates to be comfortably above zero. As long as nominal rates are close to zero and real rates are negative, the economy cannot be operating in the neighborhood of full-employment equilibrium. I developed the basic theory in my paper “The Fisher Effect Under Deflationary Expectations...and provided some empirical evidence (which I am hoping to update soon) that asset prices (as reflected in the S&P 500) since 2008 have been strongly correlated with expected inflation (as approximated by the TIPS spread) even though there is no strong theoretical reason for asset prices to be correlated with expected inflation, and no evidence of correlation before 2008. Although I think that this is a better way than the Keynesian model to think about why the US economy has been underperforming so badly since 2008, I don’t think that the models are contradictory or inconsistent[.]

(Got that? There will be a quiz afterward.)

Glasner then says that no, since we have plausible theories about how monetary policy should work, we should assume that it does work until we have convincing evidence otherwise:

I think that the way to pick out changes in monetary policy is to look at changes in inflation expectations, and I think that you can find some correlation between changes in monetary policy, so identified, and employment, though it is probably not nearly as striking as the relationship between asset prices and inflation expectations. I also don’t think that operation twist had any positive effect, but QE3 does seem to have had some...[E]ven if Waldmann is correct about the relationship between monetary policy and employment since 2008, there are all kinds of good reasons for not rushing to reject a null hypothesis on the basis of a handful of ambiguous observations. That wouldn’t necessarily be the calm and reasonable thing to do.

Basically: "No, my hypothesis is the null!"

Waldmann fires back. First, he says, "No, your hypothesis should not be the null, mine should":

1) Get the null on your side is my motto (I admit it).  You follow this.  You suggest that your hypothesis is the hull hypothesis then abuse Neyman and Person by implying that we can draw interesting conclusions from failure to reject the null.  Basically the sentence which includes the word "null" is the assertion that we should assume you are right and I am wrong until I offer solid proof.  To be briefer, since we are working in social science, you are asking that I assume you are right.  This is not an ideal approach to debate. 

I ask you to review your sentence which contains the word "null" and reconsider if you really believe it.  The choice of the null should be harmless (it is an a priori choice without a prior).  How about we make the usual null hypothesis that an effect is zero.  Can you reject the null that monetary policy since 2009 has had no effect ? At what confidence level is the null rejected ?  Did you use a t-test ? an f-test ?  "null" is a technical term and I ask again if you would be willing to retract the sentence including the word "null".

In other words: "Macro data sucks, so whoever has the burden of proof will always lose. By putting the burden of proof on me, you want me to hand you an automatic win. But no, the burden of proof is on the people who think monetary policy does work at the ZLB."

(Update: Waldmann shows up in the comments and says: Your translation of my statement about QE# isn't exactly what I meant...The evidence that the true effect of FOMC announcements on expected inflation is small is solid, clear, and strong.")

Waldmann also continues the discussion about what the data tell us with regards to whether our monetary policy is working:

[U]sing expected inflation to identify monetary policy is only a valid statistical procedure if one is willing to assume that nothing else affects expected inflation.  If you think that say OPEC ever had any influence on expected inflation, then you can't use your identifying assumption.  In particular TIPS breakevens can be fairly well fit (not predicted because not out of sample) using lagged data other than data on what the FOMC did...I think we can detect the effect of recent monetary policy on TIPS breakevens if we agree that it (including QE) is working principally through forward guidance.  There should be quick effects on asset prices when surprising shifts are announced.  QE 4 (December 2012) was definitely a surprise.  The TIPS spread barely moved (within the range of normal fluctuations).  I think the question is settled.

Glasner retorts that all this talk of "null hypotheses" and "alternative hypotheses" is bad:

What I meant to say was that even if the evidence is not sufficient to reject the null hypothesis that monetary policy is ineffective, there may still be good reason not to reject the alternative or maintained hypothesis that monetary policy is effective. In the real world, there is ambiguity. Evidence is not necessarily conclusive, so we accept for the most part that there really are alternative ways of looking at the world and that, as a practical matter, we don’t have sufficient evidence to reject conclusively either the null or the maintained hypothesis. With the relatively small numbers of observations that we are working with, statistical tests aren’t powerful enough to reject the null with a high level of confidence, so I have trouble accepting the standard statistical model of hypothesis testing in this context.

In other words, macro data sucks, so we'll never have any firm conclusions. In the absence of good data we must rely on plausibility of theory, tempered with a little bit of data.

Glasner follows this with some musings on Copernicus, Galileo, Ptolemy, etc. He basically says "Don't toss out monetarist theory just because the data isn't solidly in its favor. Someday we may get better data." He then goes on to discuss whether QE-infinity really was a surprise and which factors we should assume are more important in driving inflation expectations.

Anyway, you probably get the point by now. As I see it, the take-away from this debate should be the following:

1. Macro data is really uninformative.

2. Because macro data is really uninformative, whoever gets stuck with the burden of proof in a macro debate is usually going to lose. Hence, the way not to lose a macro debate is to play "hot potato" with the burden of proof.

3. If Fed intentions and the expectation formation process are both unobservable, we'll never be able to tell how well monetary policy really works. This is a point I've made before.

At least until we are better able to understand the intentions of the Fed and how inflation expectations are formed, monetarism will involve a big leap of faith. But the pooh-poohing of monetarism will also require a big leap of faith.

(P.S. - "WADR" means "With all due respect", IIRC. AFAIK, Waldmann was asking JOOC, but IMHO that's OK, FWIW. LOL)