What is the payoff structure of gold?

In an excellent new post, John Cochrane corrects some of Greg Mankiw's points on gold as an investment, writing:

In any case, Greg shouldn't have phrased the question, "how much gold should I hold according to mean variance analysis, presuming I'm smarter than everyone else and can profit at their expense by looking in this crystal ball?" He should have phrased the question, "how much more or less than the market average should I hold?" And "what makes me different from average to do it?"... 

As Greg points out, gold is a tiny fraction of [global] wealth. So it should be at most a tiny fraction of a portfolio.

Quite so. But even if one would not personally choose to make one-way directional bets on an asset, one might want to specify the asset's full state-contingent payoff structure, for those who do choose to speculate or to use the asset to hedge their idiosyncratic risks.

In other words, when does gold pay off? Cochrane tosses out a possible answer:

There is all this bit about gold, guns, ammo and cans of beans. If you think about gold that way, you're thinking about gold as an out of the money put option on calamitous social disruption, including destruction of the entire financial and monetary system. That might justify a different answer.

This idea is pretty common. But is it true? Would gold really pay off in the event of a calamitous social disruption? I'm really not sure that it would.

The basic idea here is that fiat money's value rests on the stability of governments; remove governmental stability, and people will go back to using gold as money (or at least to using gold-backed money), as in days of yore. If that happened, it would be handy to have stocked up a whole bunch of the suddenly back-in-use medium of exchange.

But I seriously question whether this would ever happen. See, both technology and the structure of governance have really changed since the days when gold was used for money. The assumption that the end of the Recent System (fiat money) would make us revert to the Old System (gold-backed money or gold as money) does not seem well-founded to me.

First of all, gold has always had a lot of limitations as a medium of exchange. Most notably, it is relatively easy to steal. To realize this, all you have to do is look at games like World of Warcraft, Diablo, Dungeons and Dragons, or the original Final Fantasy. In those games, gold is the money, and you often get gold not by doing an honest day's work, but by running around and beating people up and taking their gold. In other words, the entire world of modern fantasy role-playing is a subtle joke on gold's unsuitability as a medium of exchange.

Now in the past, people just sucked it up and dealt with this, spending large amounts of money and effort to guard their gold. But in the modern day, better alternatives are available. In particular, electronic security is cheaper than physical security. It's easier to guard digits than lumps of gold. In fact, in the case of gold-backed money (rather than physical gold money), you'd need electronic security in addition to guards at Fort Knox. Non-gold-backed digital currency is always cheaper to use than gold-backed digital currency.

So if fiat systems collapsed but electronic networks remained intact, it seems to me that we'd move to some sort of Bitcoin-type artificially scarce digital currency, rather than gold. Not Bitcoin itself, but some electronic currency managed by an institution with lots of staying power and respect. I'd put my money on ToyotaBucks.

OK, but what about a calamity so huge that electronic networks collapsed? In that case, wouldn't we have to go back to using physical money?

Maybe, but it wouldn't be gold. In the days when people carried around gold doubloons and whatnot as money, you had a global political system characterized by pockets of stability (the Spanish Empire, or the Chinese Empire, or whatever) scattered among large areas of anarchy. Those stable centers minted and gave out the gold coins. But in the event of a massive modern global catastrophe that brought widespread anarchy, the gold bars buried in your backyard would not be swappable for eggs or butter at the corner store. You'd need some big organization to turn the gold bars into coins of standard weights and purity. And that big organization is not going to do that for you as a free service. More likely, that big organization will simply kill you and take your gold bars, Dungeons and Dragons style.

In other words, I think gold is never coming back as a medium of exchange, under any circumstances. It is no more likely than a return of the Holy Roman Empire. Say goodbye forever to gold money.

So when does gold actually pay off? Well, remember that stories do not have to be true for people to believe them. Lots and lots of people believe that gold or gold-backed money in the event of a global social  disruption. And so when this story becomes more popular (possibly with the launching of websites like Zero Hedge?), or when large-scale social disruption seems more likely while holding the popularity of the story constant, gold pays off. Gold is like a credit default swap backed by an insolvent counterparty - it has no hope of actually being redeemed, but you can keep it around forever, and it goes up in price whenever people get scared.

In other words, gold pays off when there is an outbreak of goldbug-ism. Gold is a bet that there will be more goldbugs in the future than there are now. And since the "gold will be money again" story is very deep and powerful, based as it is on thousands of years of (no longer applicable) historical experience, it is highly likely that goldbug-ism will break out again someday. So if you're the gambling type, or if you plan to start the next Zero Hedge, or if your income for some reason goes down when goldbug-ism breaks out, well, go ahead and place a one-way bet on gold.

The only way gold will never pay off again is if practically everyone reads and believes this blog post. Not much chance of that happening!

Peter Schiff trolls Sargent and Sims

Some people on Twitter sent me this video of Peter Schiff, self-described "Austrian" and one of the world's most powerful EconoTrolls, ridiculing the two 2011 Economics Nobel winners, Tom Sargent and Chris Sims:

Schiff spends the first 9 minutes of the 11-minute video lambasting Sargent and Sims for (supposedly) not being able to answer the "poignant question" (sic) of what economic policy steps America should be taking. He repeatedly claims that Sargent and Sims can't answer this question because they don't "actually [understand] any economics". He contrasts this with himself, saying "I have real solutions based on a real knowledge of economics. I may not have a Nobel prize, but I got some street smarts."

Except Schiff's entire rant is pretty clearly just a hatchet job. Sargent and Sims didn't really fail to answer the question! Schiff just edited out the parts where they gave their answers!

Around the 9:30 mark, Schiff admits that Sims actually did give policy recommendations, and that these recommendations were very mainstream - monetary easing, short-term deficits, and long-term fiscal consolidation!

As for Sargent, Schiff doesn't cut him a break at all, but Sargent also answered the question. His full answer can be seen here. He basically says that the federal government needs to cut spending. (Update: As CA points out in the comments, Sargent might just be saying that we need to clarify which programs we're going to cut, since spending cuts are inevitable.)

So here's the question: Why does Schiff perform this unfair hatchet job on the Nobel Prize winners?

Of course I don't know the answer for certain. But it seems fairly clear that Schiff is trying to pump up his own credentials. He continually repeats that he knows more about economics than the Nobel Prize winners. And the fact that Sargent's answer dovetails with Schiff's well-known policy preferences means that Schiff either didn't understand Sargent (entirely possible), or else deliberately ignored the fact that Sargent agrees with him. That suggests self-glorification, at the expense of famous people, was Schiff's main objective.

Why would Schiff want to do this? It could be simply for fun! Being grandiose and self-congratulatory is fun (for some more than others). Or maybe it's a part of Schiff's business. As the head of a money management firm (Euro Pacific Capital), and as a seller of newsletters and writer of books about the coming collapse of the American economy, Schiff could always use some macro cred. Convincing investors that Schiff's everyman "street smarts" convey a superior understanding of the macroeconomy, while the bumbling know-nothing ivory-tower academics play with their irrelevant mathematical models, might make those investors more likely to stick with Schiff even as his repeated inflation predictions fail to pan out.

A sort of anti-intellectual folksy charm seems to be exactly what Schiff is going for. Notice how at around 9:06 he mispronounces Bernanke's name as "Bernacky". He then repeats this mispronunciation several more times (a quick search through older Schiff videos confirms that he often, though not always, mispronounces it this way). Now at first it might seem insane to hand one's wealth over to a macro investor who doesn't even know how to say the Fed Chairman's name. But who knows? Maybe there are deeply conservative people out there for whom handing a small sliver of their life's savings to Schiff is worth it purely for the sake of political affinity, as a sort of protest vote against Obama and the socialist money-printers. Or maybe Schiff just wants to signal his utter contempt for all things Fed. Or maybe after getting burned by repeated widowmaker trades, investors who buy into the "Austrian" schtick can console themselves that "Bernacky" just cheated, and went against the fundamentals of God and Market, but that that high-and-mighty bearded technocrat will get his comeuppance in the end! 

OK, I admit I really have no idea what's going on in this Austrian/Fox Business/right-wing-radio/macro-derp-herping world. At this point I'm just taking random swings for humor value. SORRY. Sorry.

But anyway, it occurs to me that the life of the Austrian investment guru is a tough one. Not only do you have to convince people that you know better economics than Tom Sargent and Chris Sims, but you have to fight rear-guard actions against others of your own kind, to prove you're The One True Austrian Guru. In 2009, a guy named Mish Shedlock, who runs his own money management business, called Schiff out on some failed exchange rate predictions and on the poor performance of one of Schiff's funds during and after the crisis. This is a bit funny, since Shedlock himself is a self-professed subscriber to "Austrian" ideas; his fund's name even sounds like Schiff's ("Sitka Pacific Capital Management" vs. "Euro Pacific Capital"). But his all-out attack on Schiff precipitated one of the great EconoTroll Battles of all time. 

Schiff quickly whirled to deal with the attack from behind. He gave Shedlock a brutal taste of his own medicine, pointing out Shedlock's own poor performance and mocking Shedlock's small amount of Assets Under Management. In response, Shedlock went for the jugular, calling out Schiff on his hyperinflation predictions and challenging Schiff to a debate. Schiff very wisely avoided debating someone with far less fame than himself, and stuck to dissing Shedlock harshly on his radio show. The highly entertaining three-year feud shows no signs of abating.

Anyway, what's the upshot of all my Schiff-trolling? The upshot is: If you see some guy making fun of top academic economists, fine. Maybe he has a good point! But if the alternative he's offering consists of a long string of failed macro predictions, loosely justified by hand-waving references to "the Austrian School" and seasoned with right-wing politics and folksy charm, beware. Chances are he's just pulling your leg. And if the top academic economists are reluctant to wade into political war zones, and unwilling to overstate the certainty afforded by their theories, well, that's probably to their credit rather than a reason to ridicule them.

Book Review: The Quants

If you want a fun, non-technical history of quantitative finance, this is your book. It traces the development of quant models, from Ed Thorp and Black-Scholes-Merton all the way through David X. Li. It explains trading strategies like statistical arbitrage in layman's terms, and offers insight into what it's like to run a trading operation, day to day. And it narrates the three-decade-long run-up to the epic finance-industry meltdown of 2007-8, including "warm-ups" like Black Monday and the fall of Long Term Capital Management. The author, Scott Patterson, writes in an accessible, engaging style, making it difficult to put the book down at times. It also does a good job of profiling some of the colorful personalities of the quant world - Peter Muller and Cliff Asness being the most colorful of the bunch.

So I definitely recommend The Quants.

Like (almost) all books, The Quants is not without its flaws. Chief among these is that the book mostly fails to deliver on one of the promises in its subtitle - it fails to give a detailed account of the quants that nearly destroyed Wall Street.

Why was Wall Street almost destroyed? The general story that I buy goes something like this:

1) Wall Street firms, by creating securitized mortgage-backed financial products, increased the demand for housing, which along with other factors helped fuel a nationwide housing bubble.

(Note: This assumes that some initial rapid price increase is needed to "jump-start" a bubble, leading to a spiral of self-reinforcing price increases, either through speculation, herd behavior, or the mistaken inference of underlying structural change, or some combination thereof. That may not be how bubbles really work, but it's currently my best guess, from what I've seen in the lab and read in the literature.)

2) Wall Street firms priced these securities using quantitative models that were fundamentally flawed, leading them to understate the risk of the mortgage-backed securities and derivatives based on these securities. Some of the flaws included eternally rising national house prices, non-time-varying correlations, thin-tailed (less risky) stochastic processes, and omission of counterparty risk.

3) These models lead banks to hold way too many of the aforementioned securities, and to borrow way too much money (leverage) to buy them. Complacent (and possibly captured) regulators and ratings agencies did nothing to stop this.

4) When the bubble popped and prices fell and correlations spiked, banks collapsed.

This story is very similar to the one given in The Quants. So Patterson does, in my view, get the crisis correct.

But four of the six people profiled in The Quants were operators of independent hedge funds - Ed Thorp of Princeton Newport, Ken Griffin of Citadel, Cliff Asness of AQR, and Jim Simons of Renaissance. Though big by historical hedge fund standards, these firms were not nearly as big (or, for the most part, as leveraged) as the banks that were at the center of the crisis - Goldman Sachs, Bank of America, Lehman, etc. And though most of the quant hedge funds suffered in the great 2008 crash, the specter of their collapse did not really threaten the system itself. In fact, as The Quants recounts, the quant hedge funds suffered their own meltdown a year earlier, in the summer of 2007, but this caused far fewer problems for the economy than the near-collapse of the big banks in 2008. Notably, none of the independent quant hedge funds were bailed out by the U.S. government in 2008 - some because they were not in danger, others because they simply weren't systematically important enough to warrant bailouts.

This is not to say that quant hedge funds can't be dangerous to the financial system; Long Term Capital Management clearly was. It's simply the case that this time, in 2008, independent hedge funds were not at the center of the crisis. They mostly sat on the sidelines, watching the carnage and hoping that they didn't die. One of the funds Patterson profiles, Renaissance Technologies, was using strategies so different from the big banks that it gained 80% in 2008. (Disclosure: The founder and some ex-employees of Renaissance Technologies have made large donations to the university where I work!)

The Quants also profiled two men who headed internal hedge funds within big banks - Peter Muller of Morgan Stanley, and Boaz Weinstein of Deutsche Bank. Weinstein's group appears to have bought lots of mortgage-backed securities, and to have lost a lot of money for the firm in the 2008 crash. But this means that only one out of the six protagonists of The Quants could plausibly be described as having "almost destroyed Wall Street".

Personally, I would have liked to have seen The Quants tell the stories of the "pricing quants" and "risk quants" within the big banks, whose models were instrumental in convincing regulators, ratings agencies, and bank executives themselves that mortgage-backed products were safe. Patterson does briefly tell the story of two such quants, Fischer Black  David X. Li, but I'd like to have seen a lot more about these guys, and about academics like Myron Scholes and Robert Merton.

Did the quants within big banks know that their models were wrong? Did they try to warn the executives not to apply the models? Did they simply shut up and take a paycheck as greedy, reckless executives misused and over-applied their models? Or did they actively promote blanket and widespread use of the flawed models, encouraging the heavy use of leverage and the holding of huge amounts of mortgage-backed products? I wish The Quants had answered this question, but it did not.

I also think The Quants displays a little too much fear of the unknown. Patterson definitely seems to regard the black-box strategies of companies like Renaissance as creepy and inherently suspicious. But I think this fear is mostly unwarranted. Any assumptions can be wrong, so any algorithm can blow up. No quant model is riskless or foolproof, and none will ever be. But that applies just as much to the intuitive trades of "shoot-from-the-hip" human traders, or to any other investing mechanism. No spooky supercomputers or secretive mathematicians were needed in order to blow up the Japanese financial system in 1989, or the U.S. financial system in 1929.

The key, as Ed Thorp is quoted as saying in the book, is in limiting leverage, so that collapses don't bring down the whole system. Limiting the systemic risk caused by "too big to fail" institutions also seems to be important. The mundane factors of leverage and bigness seem much more scary, to me, than the opacity of quant trading strategies.

Nevertheless, it is a really good book, and if you have any interest in the history of finance, you should check it out.

Infrastructure skeptics take a hit

Via Barry Ritholtz and Mark Thoma comes the following chart by McKinsey:



This chart simultaneously debunks not one, but TWO of the biggest talking points of the anti-infrastructure derpers:

Derp 1: "It's just civil engineers angling for pork!"

This is one I hear a lot. The American Society of Civil Engineers released an "infrastructure report card" that gave the U.S. a "D+". In response, anti-infrastructure people often throw up their hands and say "Of course a bunch of civil engineers want us to spend more money on civil engineering!" But now McKinsey says the same thing. The chart above cites the McKinsey Global Institute's own in-house analysis. If you think McKinsey itself is in the tank for a bunch of gold-digging civil engineers,you're...well, it sounds pretty silly when you say it out loud, doesn't it?

As an aside, the McKinsey report also cites independent figures from the World Economic Forum, the Army Corps of Engineers, and the Federal Transit Authority. Everyone agrees that the U.S. needs more infrastructure spending.


Derp 2: "Oh yeah? What about Japan in the 90s?"

A lot of anti-infrastructure people bring up Japan's infrastructure splurge in the 1990s. Japan built bridges to nowhere (I drove across one, once; "nowhere" is not an exaggeration), concreted over riverbeds and parks and beaches, and generally committed an epic waste of money, labor, and concrete. We'd commit the same error if we spent more on roads and bridges, right?

Wrong. As the McKinsey report shows, Japan still spends much more on infrastructure than it needs to (and this, btw, is after a dramatic reduction in spending in the '00s). That is in stark contrast to most other countries. So this report clearly says that we are not Japan. We are on the opposite side of the optimal point. They need less, we need more.


In conclusion, McKinsey just killed two of the main anti-infrastructure arguments. Increasingly, all the anti-infrastructure people have left is their derp. At a time when interest rates are super-low and millions are out of work, there is no good case against a big blast of infrastructure spending. Let's do it right now.

Update: Numbers! We need to spend an additional $1 trillion (that's 1000 $billion) dollars on infrastructure over the next 5 years. or about 1% of GDP.

Learn the basics of New Keynesian models without hard math

This post by Miles Kimball is a master class in how to explain ideas effectively. In one post, he explains the core ideas of what he calls "Neomonetarism", which I tend to just call "monetarism", and which most economists would refer to as "New Keynesian models with investment". This sort of model is squarely in the mainstream of what modern business cycle theory. Miles' academic work on Neomonetarism in the 1990s is heavily cited by Frank Smets and Raf Wouters, creators of the workhorse New Keynesian model used by central banks.

Miles manages to explain the ideas of the model without any reference to difficult math, while providing a clear and lucid description of most of the "microfoundations". He also explains what the "natural rate of interest" means in the context of these models (hint: there are actually two of them). Note that the policy recommendations that pop out of Miles' model are only slightly different from what Scott Sumner, David Beckworth, and other "market monetarists" have been advocating through their blogs.

So if you want to understand the way that mainstream business cycle theorists think about the macroeconomy, but you don't have the time or expertise to pick through a DSGE model, Miles Kimball's explanation is your constrained-optimal strategy for achieving understanding.

OK, that was a short post.

What, you wanted me to argue with the model? OK, OK, I guess I can play Devil's Advocate.

What are the potential shortcomings of this sort of model? In a 2012 speech (flagged helpfully by Steve Williamson), Charles Plosser lays out a number of them. Note that Plosser is a pioneer of the rival Real Business Cycle type of modeling, which generally lost out to New Keynesian models as the dominant form of business cycle theory, though it remains a substantial minority view. 

Plosser:

A...friction often assumed in Keynesian DSGE models is that firms and households have to wait a fixed interval of time before they can reset their prices and wages...A rule of the game in these models is that the interactions of these nominal frictions with real frictions give rise to persistent monetary nonneutralities over the business cycle... 

[Realistic price adjusting strategies] are ruled out by the “rules of the game” of New Keynesian DSGE modeling. 

Another important rule of the game prescribes that monetary policy is represented by [a rule] that policymakers are committed to follow and that everyone believes will, in fact, be followed...[T]his commitment is assumed to be fully credible according to the rules of the game of New Keynesian DSGE models. Policy changes are then evaluated as deviations from the invariant policy rule to which policymakers are credibly committed. 

I have always been uncomfortable with the New Keynesian model’s assumption that wage and price setters have market power but, at the same time, are unable or unwilling to change prices in response to anticipated and systematic shifts in monetary policy. This...raises questions about the mechanism by which monetary policy shocks are transmitted to the real economy in these models... 

From a policy perspective, the assumption that a central bank can always and everywhere credibly commit to its policy rule is, I believe, also questionable...[C]ommitment is a luxury few central bankers ever actually have, and fewer still faithfully follow...Policy actions have become increasingly discretionary... 

Given that central bankers are, in fact, acting in a discretionary manner...how are we to interpret policy advice coming from models that assume full commitment to a systematic rule? [A] number of central banks have been openly discussing different regimes, from price-level targeting to nominal GDP targeting. In such an environment where policymakers actively debate alternative regimes, how confident can we be about the policy advice that follows from models in which that is never contemplated?

What Plosser is arguing is that New Keynesian models have unrealistic microfoundations. Specifically, the "sticky price" mechanism and the "monetary policy rule" mechanism, both highly important for New Keynesian models, don't seem realistic to Plosser.

On one hand, this sort of criticism might sound a bit rich coming from a pioneer of RBC theory, whose microfoundations - perfectly flexible prices, technology that vanishes from human knowledge, etc. - are even less realistic. But I think the criticism itself is worthwhile.

The "monetary policy rule" is not as big of a problem as Plosser thinks, because more recent New Keynesian models, like the aforementioned Smets-Wouters model, allow the monetary policy "rule" to fluctuate randomly, meaning that they don't assume that the central bank can perfectly commit to future policy.

But the "sticky price" microfoundation remains troubling. You really do need sticky prices for these models to work. More specifically, as Miles points out in another paper with Bob Barsky and Chris House, you need durable goods prices - houses, cars, TVs, etc. - to be sticky. But why these prices would be sticky, and when they would be more sticky or less sticky, is not well understood.

Yes, sticky-price models do appear to fit the macroeconomic facts much better than do "flexible-price" models like Plosser's RBC. But sticky prices could just be a stand-in for something else. As Greg Mankiw and Ricardo Reis point out, "sticky information" - i.e., people simply not paying enough attention to price changes -  gets you similar results.

So I'm not saying I think we should chuck the models of Miles, Smets/Wouters, etc. out the window. Far from it. First of all, they may allow slight improvements in forecasting (and I am not as quick as most macroeconomists to dismiss the importance of forecasting!). And on the policy advice front, well, the evidence is strong that monetary policy sometimes really does work in the way we think it should (a clear and simple example being the Volcker disinflations; more complicated examples involving impulse responses and event studies and moments of aggregate joint time series are also available).

I just think we don't yet really know why monetary policy sometimes works. And because we don't know why it works, there's the possibility that monetary policy will do screwy things, or fail to work the way we think it should, in some situations. A liquidity trap situation, with prolonged deflation, may be one of those situations. I think Miles' "electronic money" idea should be tried (especially in Japan), but I'm not as confident as Miles that it will work as advertised!

Is the interest rate on reserves holding the economy back?

Martin Feldstein claims to have solved the puzzle of why Quantitative Easing has not resulted in higher inflation:

The link between bond purchases and the money stock depends on the role of commercial banks’ “excess reserves.” When the Fed buys Treasury bonds or other assets like mortgage-backed securities, it creates “reserves” for the commercial banks, which the banks deposit at the Fed itself... 

The link between Fed bond purchases and the subsequent growth of the money stock changed after 2008, because the Fed began to pay interest on excess reserves. The interest rate on these totally safe and liquid deposits induced the banks to maintain excess reserves at the Fed instead of lending and creating deposits to absorb the increased reserves, as they would have done before 2008. 

As a result, the volume of excess reserves held at the Fed increased dramatically from less than $2 billion in 2008 to $1.8 trillion now. But the new Fed policy of paying interest on excess reserves meant that this increased availability of excess reserves did not lead after 2008 to much faster deposit growth and a much larger stock of money. 

So it is not surprising that inflation has remained so moderate – indeed, lower than in any decade since the end of World War II. And it is also not surprising that quantitative easing has done so little to increase nominal spending and real economic activity.

This explanation seems highly dubious to me.

Econ 102 says that banks lend money to long-term risky projects. They choose to lend if the expected real rate of return from a risky project is greater than r + S, where r is the safe real rate of return, and S is some required spread.

With IROR > T-bill rate (as now), the IROR is the safe asset. With IROR < T-bill rate, the T-bill rate is the safe asset.

The IROR is 0.25%. The T-bill rate is just over 0%. This means that the difference in the expected real rate of return between a world with an IROR and a world without an IROR is about 0.25%. In a world without an IROR, banks lend to any risky project with an expected real rate of return of S. In a world with an IROR, banks lend to any risky project with an expected real rate of return of S + 0.25%.

Therefore, what Feldstein is asserting is that there is an absolutely huge number of risky projects whose expected return is between S and S+0.25. He is asserting that if we lowered the safe rate by 0.25%, a huge panoply of projects would then become worth investing in, and a huge torrential flood of reserves would be released into the economy, boosting inflation and lowering unemployment in the process.

Does that seem reasonable? To me, that does not seem reasonable in the slightest. First of all, it is a priori dubious, because of the small numbers involved. Second, since S actually differs from bank to bank, depending on lots of different factors, it makes sense that if Feldstein were right, then some of the big banks would be lending like gangbusters and others wouldn't. Is this what we see? To my knowledge, it is not.

Therefore I conclude that the IROR is not the reason why QE has not translated into higher bank lending, higher inflation, and lower unemployment. The answer must lie elsewhere; it must be the case that either S is very high, or there are very few projects with decent expected rates of return, or maybe some sort of institutional constraint on the speed with which banks can ramp up lending. But that little 0.25% IROR can't be what's holding the economy back.


Update: Also, as Matt Rognlie emails to remind me, Japan didn't pay interest on reserves from 2001 to 2008. And Japanese bank lending went nowhere during that period despite a burst of QE. So that is another nail in the coffin of the IROR hypothesis. Always remember to look at Japan!

When have econ blogs changed your mind about something?

There are quite a lot of strong priors in the world, and there's also quite a lot of confirmation bias, which is even worse. I'd like to think I'm about as susceptible to these things as the average person. But there are also a lot of cases when reasonable argumentation has changed my mind about this issue or that. Thinking back, I can remember several instances in which reading econ blogs made me totally switch my position. To wit:

1. Tyler Cowen convinced me that the Great Stagnation is real.
At first I was very skeptical; citing slow productivity growth as evidence of stagnating technology seemed a bit like low-frequency RBC, and the ongoing boom in the productivity of durable-goods manufacturing seemed to belie the technological stagnation thesis. But Tyler brought two pieces of evidence that changed my mind. First, the point that the Stagnation is not just technological, but also resource-based - we have mostly run out of unexploited natural resources and easy educational gains - was a key one. Second, unlike in RBC models, the Great Stagnation can mostly be tied to an observable piece of technological stagnation: energy. Cheap oil began to end around the same time that the Great Stagnation began. That's too striking to ignore, though I still suspect that globalization may also be affecting the TFP figures.

2. Paul Krugman convinced me that American politics is largely about race and the South.
I was raised to believe that American politics was all about class; the GOP was the party of the rich and the Democrats were the party of the poor. My parents told me that, my teachers told me that. Although I still think class matters, on the margin, I now think that race and the legacy of the Confederate civilization matter a lot as well, especially on the margin. Paul Krugman basically convinced me of that all by himself back in the early 2000s, though nowadays it seems that everyone has picked up this thread. Krugman is still saying smart things about race and politics, however.

3. Alex Tabarrok and Matt Yglesias convinced me that the patent system is broken.
I was raised to love patents - Public goods! Reward the nerds for their hard work and smarts! But after reading a lot of blog posts by Tabarrok and Yglesias about the abuses of the system, I have come to believe that the modern American patent system is fundamentally broken and needs substantial reform, and that lots of patents - perhaps even the majority of patents - are doing more harm than good.

4. The whole blogosphere convinced me that the Reinhart-Rogoff 90% thing was total BS.
I am not ashamed to admit that I bought into the Reinhart-Rogoff talking point that a 90% debt-to-GDP ratio spelled trouble for growth; anecdotally, high debt and slow growth had coincided in Japan, and there were some theoretical reasons to believe in some sort of negative debt-growth relationship, and I assumed R&R had done their homework, and I also had been convinced by their point that financial crises prolong subsequent recessions. So I accepted their 90% number, though I maintained some reservations due to the general difficulty of drawing any kind of conclusions from that kind of data. But then...well, the rest is history. Miles Kimball's posts on the subject were possibly the most convincing of all. 90% is well and truly dead.

5. Ramez Naam convinced me that solar is real and huge.
I used to buy the conventional wisdom that solar costs would always be too high for solar to be a viable cost-effective alternative energy source without huge government subsidies. My hopes for alt-energy were always pinned on nuclear, and maybe advanced biofuels. Then Ramez Naam came along and demolished my entire worldview with a single post. Of course trends can stop, but this trend is too long and too strong to hand-wave away. Solar is real, and it's huge. If the cost trend holds just a little longer, the point where unsubsidized solar is cheaper than coal is coming very soon - maybe five years from now.


There were also some instances in which my perspective didn't reverse entirely, but became much more mixed and nuanced, after reading blogs. For example:

6. Steve Williamson convinced me that the macro field is structurally biased toward monetarism.
I can't find the post(s) now, but Williamson has pointed out that central bank macroeconomists have a strong incentive to choose and promote models in which independent, active central banks are the most important stewards of macroeconomic stability. Since a big percent of top macroeconomists work at central banks, this is a non-trivial observation. I was trained to be pretty monetarist (by Miles Kimball and somewhat by Bob Barsky), but Williamson's point was a good one, and has given me pause. Of course, it's a bit of a cynical Marxist type point, but a good one nonetheless.

7. Paul Krugman convinced me that Japan's 1990s stimulus had some positive effects.
Living in Japan in the mid 2000s, I picked up the conventional expat wisdom that Japan's "fiscal stimulus" was a total waste, driven by clientelist construction spending and LDP corruption, concreting over the riverbeds and building bridges to nowhere. And while I still believe there was a ton of waste, Krugman blogged some data showing how mild Japan's two recessions in the 90s were, despite the incredible severity of the country's financial crisis. That's a powerful argument. I now believe that though Japan's 1990s spending spree probably wasn't worth it on balance, it probably was not quite as unmitigated a waste as I had thought.


Those are most of the examples I can think of. Not a lot, but not nothing either! Derp is strong, but it is not all-powerful.

What are your examples? Other bloggers, feel free to give your lists as well. (Note: To make the list, a blog has to have actually changed your mind about something, not just convinced you of a position where you had none to begin with!)


Update: Cardiff Garcia gives his list.

The hard-money people throw Gene Fama under the bus

In the last year, the Macro Wars have been mostly going well for the Monetarist Alliance. My prediction that the Fed would shy away from further QE was dashed, and Bernanke came through for the Alliance in a big way with QE-infinity; Japan's central bank has promised even more. Meanwhile, the Hard-Money Coalition has lost a lot of intellectual cred, as inflation has quite spectacularly failed to materialize in response to ATMP ("All This Money Printing").

But the Hard-Money Coalition is far from beaten. Driven from the Inflation Hawk line of defense, the HMC is regrouping and falling back. The new line of defense is the Financial Instability argument. Basically, the idea is that even if QE doesn't create inflation, it distorts financial markets. From the ramparts of Castle WSJ, Amar Bhide and Edmund Phelps write:

The Fed said it would end easing at serious signs of faster inflation. But as the housing bubble that preceded the financial crisis showed, imprudent speculation can be destructive without high inflation. Today we have banks, insurance companies and pension funds leveraging their assets and loading up on credit risks because prudence cannot provide acceptable returns.

And back in January, John Taylor alleged that QE would cause "reaching for yield":

The Fed’s current zero interest-rate policy also creates incentives for otherwise risk-averse investors—retirees, pension funds—to take on questionable investments as they search for higher yields in an attempt to bolster their minuscule interest income.

That prompted a fiery rebuttal from General Miles Kimball of the Monetarist Alliance. See also some responses by Mike Konczal, Nick Rowe, and Brad DeLong. (Also see this somewhat related debate between David Beckworth and Andy Kessler.)

Basically, what the Hard-Money Coalition is doing is throwing the Efficient Markets Hypothesis under the bus. Sorry, Gene Fama! (Note: Someone really needs to start the #sorryfamanists Twitter hashtag.) For a bit more on just why the "reaching for yield" idea contradicts the EMH, see this Krugman post.

This is a savvy switch in tactics. Inflation is something we haven't seen since the 70s. Financial instability, however, is something we've seen a lot of recently. The housing crash and financial crisis convinced dang near everyone outside of finance and econ departments that markets are unstable, especially housing markets and markets driven by credit and leverage. Two groups of econ commentators - Austrians and Post-Keynesians - emerged from the woodwork and occupied much of the econ and finance blogospheres.

The subtext of the "financial instability" argument, and what that some people say explicitly, is that QE is creating - might one even say "inflating"? - a new housing bubble. It's 2006 all over again!

So the Hard-Money Coalition has just recruited itself a huge new batch of allies, many of them from the liberal side of the American political divide. For example, here is George Soros warning that central banks are creating financial instability. Here is Yves Smith saying much the same. And here's Cullen Roche warning explicitly of a new, QE-fueled housing bubble (see also here).

This new Macro War is much less of a liberal-vs.-conservative thing than was the fight over stimulus. It's more about mainstream macro vs. a coalition of non-mainstream groups. Macroeconomics is currently dominated by the ideas of Milton Friedman, especially the idea of a NAIRU, short-term monetary non-neutrality and long-term monetary neutrality, and above all the primacy of monetary policy. This is reflected in the dominance of the New Keynesian approach in business cycle theory and in central banks, and in the centrality of Friedman's ideas in most Econ 102 (introductory macro) classes. But if the "financial instability" meme takes root, this consensus is going to find itself facing a huge and unexpected new challenge.

So it's going to be interesting to watch.

Now where does little insignificant gadfly Noah Smith stand in this new battle? On one hand, I definitely think financial markets are unstable, and that bubbles are the biggest and most damaging manifestation of that instability. And the experimental evidence certainly suggests that more liquidity sloshing around in a market can give rise to bubbles, just as Austrians and Post-Keynesians believe.

But then again, I don't see a lot of anecdotal indication that QE is creating Housing Bubble, The Sequel. I agree with Robert Shiller that bubbles are characterized by optimistic expectations and general excitement. I don't see a lot of excitement about eternally-rising asset prices or a New Economy or a "This time is different" mentality. In fact, if John Taylor is right that QE is creating fear and uncertainty about future unwinding, then that seems like it should be pushing asset prices down, not up. It is well known that lower interest rates (or expectations of lower future interest rates) cause the fundamental value of houses and bonds to rise...so even if QE raises asset prices, that does not automatically indicate Bubble. I think it's likely that since humans tend to overweight recent experience in our models of how the world works, that we are too jittery about a repeat of the recent crisis, and probably paying too little attention to whatever the next crisis is going to be.

So while I'm not ruling out the idea that QE could create financial instability, I don't think it's going to be of the Big Bubble type. It would have to be something weirder and more subtle. Maybe interest rate spikes in Japan are this kind of thing. I'm not sure. So for now, I'll be watching this new Macro War from the sidelines.

(Of course, the question of financial effects of monetary policy, and whether the costs outweigh the expected benefits, is far too big to be dealt with so glibly, especially because so few models include this sort of thing. So this is just the beginning...)

How normal people see macroeconomics

Most of the time, econ bloggers and columnists write as if we were speaking to an audience that has taken a few econ classes. But the more widely read our posts and columns become, the more our real audiences fail to fit this ideal. Most people who read us are smart and educated. But smart and educated non-economists ("normal people", if you will) see econ - and especially macro - in fundamentally different ways from economists.

I've been thinking about these differences for a while, and I've reached two major conclusions:

1. Normal people see macro as inherently political.

2. Normal people see macro as being mostly about redistribution rather than about efficiency.

The first of these tendencies can be seen in this video. The video features Mike Sacks of the Huffington Post interviewing Miles Kimball and three economics writers. The interview itself is very interesting and informative (Umair Haque's ramblings notwithstanding). Miles especially does an excellent job of putting macro ideas in simple terms. Mark Gongloff is also solid.

But scroll forward to the 10 minute mark. Mike Sacks, certainly an educated and intelligent guy, admits how little he understands macroeconomics. This amuses him so much that he starts laughing at himself. Groping for the rudiments of an understanding, he instinctively tries to label economic philosophies as "liberal" and "conservative". At the end of the video, he reads Miles Kimball's bio, and finding Miles to be a political independent, moderate, and maverick, declares that Kimball is his favorite sage among those present (a very good choice, I must say, for more reasons than just the one Sacks gives).

Americans in particular have come to understand almost everything through the lens of the left-right divide in American politics. Science has obviously not been exempt from this trend, as the fights over evolution, climate science, cosmology, vaccination, and GMO crops have shown (no word yet on whether Newton's Laws of Motion are commie scum or fascist bastards). Economics, with all its public policy implications, never had any chance of escaping the tribalist wave. Even basic economic numbers are subject to partisan disagreement...at least until people are paid to get them right. And then there's the partisan bias in economic forecasts.

As for my second observation - that people understand arguments for redistribution but don't understand efficiency arguments - I have no hard data to back that one up. My observation comes from long experience and countless interactions with friends and relatives and strangers in cafes, blog commenters and op-ed writers and EconoTrolls. Among the things I've noticed are:

1. Normal people talk about economic "schools" much much more than do economists.

2. When normal people talk about the consequences of stabilization policy (monetary and fiscal policy), they often talk about the impact on the rich and poor, the benefits to big banks, and the "fairness" of the policies. In contrast, economists rarely talk about these things.

In a certain sense, the normal people's approach makes more sense than that of the economists. We are an incredibly rich economy - the world's richest large economy by far. This means there are relatively few efficiency gains to be had, but the impact of any redistribution of our titanic wealth will be enormous. Economists usually try to be impartial, shrugging and saying "Rent is rent!" when confronted with questions of distribution, or pooh-poohing welfare analysis as the province of philosphers and dorm-room discussions. They focus on efficiency because a Pareto improvement is something that everyone can get behind (in fact, that's how it's defined). In the process, they ignore the main issue that is usually on the mind of someone thinking about the economy: "What's in it for me?"

So most normal people seem to see macroeconomics as political (even if most economists don't!), and see redistribution as the main question. The result is that public discussions of macro, on the blogs and elsewhere, usually break down into tribal camps, and thinkers are often seen more as tribal champions than as technocratic advisors or sources of intellectually interesting ideas. Many people see the "-isms" of macro - "New Keyneisanism", "New Classicalism", etc. - as political advocacy rather than as dispassionate scientific attempts to explain the world around us.

If monetarists or New Keynesians (is there a difference?) suggest monetary expansion, for example, a lot of readers see it instead as a liberal attempt to use inflation to redistribute money from rich creditors to poor debtors, while a few see it as a conservative attempt to boost the profits of big banks. Only a small minority seem to consider the question of whether monetary expansion is a Pareto efficient response to the business cycle. Because of this, monetarists like Scott Sumner often spend a lot of time "punching hippies" on every issue other than monetary policy, trying to avoid being tarred as hippies themselves for their lack of fear of inflation. (Note to Sumner: This strategem has quite noticeably failed to convince most conservatives to support anything remotely resembling NGDP targeting.)

(Update: Sumner pleads not guilty to hippie-punching. Perhaps the direction of Sumner's punching is determined more by path-dependent stochasticity, and less by game theory, than I had assumed. Sumner then accuses me of strategic Sumner-punching. I also plead not guilty; I would only Sumner-punch for the sake of pure entertainment. I have my principles, after all!)

In other words, econ, like everything else in modern America, seems to have been caught up in the great war of Tribal Realities that has rent apart everything in our society. Even the most powerful and brilliant individual intellectual is like an ant compared to those titanic forces. And until the great War of the Tribes is over, our feeble attempts to show off our scattered, tiny, incomplete insights into Extant Reality will be lost amidst the tossing maelstrom of Tribal Reality. But in addition, it also means that most macroeconomists are ignoring the question most people care about - the question of "Who benefits from stabilization policy?".

Of course, I could be wrong about this. Much of my "data" is just anecdotal, after all. There's a serious selection bias at work, since those stirred by tribal passions will be more likely to leave a shrill comment on a blog, or start an argument at dinner.

What do you think?

"Asset price inflation" is not inflation

Situation 1: Imagine there is a new craze for meatloaf. It's a fad. Meatloaf restaurants pop up all over America, from Park Avenue to Lubbock, Texas. As a result of this increased demand, the price of beef goes up.

Situation 2: Imagine everyone in the country magically agrees to change the definition of "one dollar" to be what used to be called "fifty cents". The price of everything would immediately gets multiplied by two. That includes beef.

The first of these situations reflects an increase in the degree to which people are willing to give up other useful stuff - back massages, cars, etc. - for beef. The second does not. Hence, we would like to differentiate between those two situations. Traditionally, economists do this by calculating a "price index", which is an average price level of all the useful stuff that people buy. In the first case, the price index will go up only a little, or maybe even not at all, as a result of the increase in desire for beef that led to beef's price rise. This, economists call a "relative price change". But in the second case, the price index goes up a lot as a result of the change in the unit of account. This, economists call "inflation".

There are some subtle points here, concerning what would ultimately happen as a result of these two situations, and how we would measure these changes if we were gathering data. But you get the basic point. Prices can change because of changes in the value of one thing relative to another, or they can change because of changes in the unit of account. We want to distinguish between these things. And "inflation" is the word we have chosen to refer to the latter kind of change, not to the former.

This is why I don't like the term "asset price inflation". This is a term that some people use to refer to increases in asset prices. They use the word "inflation" for two reasons:

1. They think that asset prices change in response to monetary policy. The price index is also widely believed to change in response to monetary policy. Hence, they see an analogy.

2. They think that asset prices, such as the price of used houses, should be included in the Consumer Price Index (currently only "housing services", not house prices themselves, are included in the CPI).

I could argue with either or both of these. But I am not going to. Because the reason I dislike the term "asset price inflation" has nothing to do with either of these points.

Suppose we did include house prices directly in the CPI. They would still be only a small part of the CPI. Suppose house prices were 10% - a hefty chunk - of the "market basket" that is used to calculate the CPI. And suppose house prices went up by 10% while the rest of the price index remained unchanged. That would increase inflation by only 1 percentage point.

Most of the increase in house prices (9/10 of the increase) would not represent inflation. It would represent a rise in the relative price of houses. It would mean that people are willing to (implicitly) give up a larger quantity of back rubs, iPads, cars, and meatloaf in order to obtain a house. It would not indicate a change in the unit of account. The unit of account would remain relatively constant, changing by only one percent, even as house prices rose very substantially.

So to point to an increase in the price of houses and to call that "asset price inflation" is just as misleading as it would be to point to an increase in beef prices and call that "beef inflation". There's only one kind of inflation, and that is inflation itself. You have to add everything in before you can tell me how much inflation there is.

Now at this point you may be thinking, "OK, I see your point, but so what? House prices are important, so central banks should pay attention to relative changes in house prices. So this is all just semantics. Call it inflation or call it whatever, rising house prices still means the Fed needs to tighten."

But here's the thing: We know inflation - the real inflation, i.e. changes in the price index - is bad if it goes too high or too low. We know that, whether the ideal rate of inflation is 1% or 6%, it almost certainly isn't 15% or -4%. Within certain bounds, price stability is good. With asset prices, we have no such guide. If houses go up in value by 15% in a year, are we sure we want to push them back down? Our recent experience with a housing bubble probably convinced a lot of people that the answer is "yes", but remember that housing price rises don't always indicate a bubble. And on the flip side, suppose house prices went down by 4% in a year. Would we want the Fed to always push that back up?

What I'm saying is: Even if the Fed really ought to respond to asset prices, the way in which is should respond is not very similar to the way in which it should respond to inflation.

So even the loose, casual analogy between inflation and asset price changes is flawed. They aren't even similar phenomena. They don't generally have similar impacts on the real economy. And they don't demand similar responses from the Fed. So let's stop using the misleading term "asset price inflation"! Let us strike it from our lexicons!!

Peak Oil is dead! Long live Peak Oil!

One of my favorite websites, The Oil Drum, is shutting down, and I am mad! Everyone is attributing the shutdown to the death of the "Peak Oil" meme, which in turn is attributed to fracking. The first is probably true; Peak Oil mania is over. But the second is false. Fracking has not killed Peak Oil. It just hasn't fit the narratives that many of the Peak Oilers spun.

The thesis of Peak Oil is simple: Global oil production will soon peak and begin to decline. But there were two possible stories that the Peak Oilers told about how this would happen:

"Good Peak Oil": In this case, we find something that's better than oil, and switch to that, just like we once transitioned away from whale oil. In this case, oil prices and production would both fall.

"Bad Peak Oil": In this case, we don't find something better than oil, and as oil becomes more scarce, the price would go up, while oil production and overall economic activity both contracted.

What we got was neither of these. Or more accurately, we got a little bit of both, coupled with something else that doesn't fit with either story. What happened was this:

1. Global demand for oil increased, due to growth in emerging markets, pushing up oil prices in the 2000s - from around $20 to over $100, a five-fold increase.

2. At the new higher price, it became economical to tap expensive oil sources like tight oil (fracking), deepwater oil, and oil sands.

3. Even at the new higher prices, it has not been economical to increase "conventional" oil production. Instead, all net production increases have come from "unconventional" sources. And most of that "unconventional" production is not actually "oil" at all, but "liquids", which includes things like natural gas liquids.

4. There was a several-year lag in the mid-2000s where global oil production plateaued even as prices increased. This culminated in a dramatic spike in oil prices in 2007-8 which then subsided due to the global recession and the dramatic increase in unconventional oil production.

5. Oil prices are still over $100, even as global growth has been slow. Meanwhile, oil usage in rich countries has declined significantly.

This story does not easily fit with either of the Peak Oil scenarios. But it has important elements of both.

First of all, the peak in conventional oil, coupled with a dramatic surge in unconventional oil, looks a lot like the "Good Peak Oil" scenario, in which technology produces a new alternative energy source, and we switch to the new thing.

But the seemingly permanent increase in oil prices, and the fall in oil demand in rich countries, fit the "Bad Peak Oil" story. It indicates that the world is hitting oil supply constraints.

(And of course what the Peak Oilers missed was unconventional oil itself. Some of them missed the technology entirely, while others merely failed to anticipate that the industry's terminology would switch from "oil" to the more weaselly "liquids".)

So what happened was NOT that we switched to something better than oil. We switched to something worse than conventional oil: unconventional oil, which is more expensive to extract and/or to refine into usable products. This has left us permanently poorer than we would be if conventional oil hadn't hit global supply constraints. Filling up your gas tank is twice as expensive now, in real terms, as it was two decades ago. And that looks unlikely to change. In the wider economy, increased transportation fuel costs may be a main driver of the Great Stagnation, which manifests most clearly in the stagnation of transportation technology since the 1970s.

Basically, what happened is this: Scarcity attacked humanity, and Human Ingenuity battled back. Through heroic efforts, doomsday was averted. But Ingenuity did not win a smashing victory, as it did when we switched from wood to coal, or from whale oil to oil. Instead, humanity was forced into a fighting retreat, with Ingenuity executing a brilliant rear-guard action and forcing Scarcity to call off its pursuit...for now. But humanity has lost ground.

And Scarcity may not wait very long before launching another attack. Future increases in shale oil production (including tight oil and oil shale) is likely to be a lot more expensive than the low-hanging fruit we have picked thus far. Coupled with continued rises in developing-country oil demand and continued decline in conventional oil fields, this could cause another rise in oil prices. That will bring back the "Peak Oil" meme, which only seems to interest most people as an investment story. But sadly, The Oil Drum will not be around to chronicle the return of Peak Oil.

In the meantime, whatever you think of the predictive prowess of the Peak Oilers, the policy implications of the permanent transition from cheap oil to expensive oil are the same. Humanity is running out of high-quality, fungible, energy dense transportation fuel, and there is no substitute on the horizon. Creating a substitute - be it biofuels, batteries charged by cheap solar, or whatever - is going to take a lot of research, which is going to cost a lot of money. And realistically, the only entity that will put up that kind of money is the government.


Update: On Twitter, Kate Mackenzie suggested I mention climate change. In the heyday of the Peak Oil meme, some people did suggest that Peak Oil would save us from climate change. But this was always a complete fantasy; the numbers clearly don't add up. Electricity generation produces enough CO2 to cook the planet without needing help from dirty transportation fuel. The real hope for stopping global warming lies in low-carbon electricity generation - switching from coal to gas in the very short term, then switching to solar a few years later.

Update 2: Karl Smith disagrees with my post. Matt Yglesias effectively rebuts K. Smith with a single graph, writing "The good old days of genuinely abundant liquid fuel really do appear to be behind us." Exactly.

Update 3: In the comments, Robert Frey makes a VERY important point about conditional vs. unconditional prediction:

Arguing that a peak oil prediction was foolish or inaccurate because it was not realized is a bit like arguing that an inoculation program was unnecessary because the epidemic never occurred. The geologists who made such predictions were not fools. Their models were well thought out and carefully validated. They understood the conditions and limitations of their prognostications and saw themselves not as doomsayers but as agents of change. We owe them gratitude and not disdain.

YES. Exactly. If physicists predict that an asteroid is going to hit Earth, and so in response we send a bomb and successfully divert the asteroid, you hail the physicists as heroes, rather than deriding them as Chicken Littles. This is something that too many economists and economics an finance commentators tend to get wrong when talking about "predictions". Thank you.

Japan and the liquidity trap

In my last post, I claimed that the main theoretical framework that people use to think about the Japanese stagnation - the mainstream Woodford New Keynesian model and its baby brother the Econ 102 AD-AS model - didn't apply, because prices couldn't be sticky for 20 years. Paul Krugman agreed that the standard model is inapplicable, but took me to task for forgetting about the liquidity trap.

I didn't forget about the liquidity trap. I just didn't talk about it. Why? Because it's not what most people are using to think about Japan. A liquidity trap may look like something you can just tack on to a standard Woodford or AD-AS model and obtain mostly the same results...but really, it changes the whole thing. And most macroeconomists (that I have seen) are not paying a ton of attention to the Zero Lower Bound; they are still thinking about things in the AD-AS or Woodford paradigm, where unemployment involves things like sticky wages. So that was the paradigm I wanted to address in my earlier post.

I should say that although I haven't ground through the mechanics of a liquidity-trap model, I am favorably disposed toward the models. Why? Because they seem to fit some important stylized facts. The idea of the "paradox of thrift" seems to match what we saw in the U.S. after the 2008 crisis; American savings rates spiked but inflation fell and growth fell, making the resultant deleveraging relatively modest. And the idea that the Zero Lower Bound is real and important seems borne out by the difficulty that central banks have had in creating growth or inflation via Quantitative Easing. Certainly, liquidity trap models are consistent with one important piece of the Japan story: the coupling of persistent deflation with zero nominal interest rates.

As I said in the update to my last post, liquidity trap models might be able to explain Japan's stagnation where mainstream New Keynesian/AS-AS models fail. Liquidity trap models might have multiple equilibria, or very very long-lasting impulse responses to demand shocks. I'm not sure whether they do have these features, but it seems that they might. And they might contain some reason why Japan might be more susceptible to a super-long deflation than other countries.

BUT, here is the thing about liquidity trap models: They are not yet well-developed or well-explored, compared to other kinds of models. The liquidity trap is the subject of only a few theoretical papers that I know of. The main fully-specified NK-with-liquidity-trap DSGE model I know of - Eggertsson & Woodford 2003 - doesn't even include capital investment or supply shocks. And very few researchers have yet tried to take the model to the data to see how well it fits in general (as opposed to simply "explaining" the stylized facts it was invented to explain). This is in contrast to the Woodford/AD-AS paradigm, which has been very thoroughly explored by many many macroeconomists for decades. We know all about how Woodford/AD-AS works. But there are many things about liquidity trap models that we don't yet know or understand. And these gaps lead to puzzles when we try to apply the theory to the real world, even in a casual manner.

For example, the strong form of the Paradox of Thrift says that the private sector's attempts to save more will mostly be thwarted. But Japan has successfully deleveraged since its 20-year deflation began! Check it out:

That is a huge, steep, sustained fall in private-sector debt (the blue line) starting in about 1999 (note that it's a debt/GDP ratio, so this is in real terms). By the eve of the 2008 crisis, Japan's private debt was lower than at any time since 1964. And all through that successful rapid deleveraging, there was indeed deflation. And after that massive deleveraging, deflation or ~0% inflation continued.

That's not a result you would expect from knowing the Paradox of Thrift. It may well be that this sort of thing can happen in a liquidity trap model - it may not be a true "puzzle" or "anomaly" - but you wouldn't guess this from the basic intuition.

Another Japan puzzle for liquidity trap models is that Japanese households don't seem to behave the way that the models expect them to. During Japan's long deflation, household saving rates fell dramatically:

This is NOT what households are supposed to do in a liquidity trap, right? Japan's increase in private saving has all come from corporations. And I suppose you could wave a hand and say that the "representative household" owns the "representative firm" and makes corporate savings decisions. But even with increased corporate saving, Japanese savings rates fell during the deflation:



To my knowledge, liquidity trap models don't (yet) model the saving behavior of firms, since they don't (yet) include capital investment. They also don't (yet) model the effects of supply shocks in a liquidity trap; this is probably relevant for Japan, since its economy experienced a boom in 2002-2006, probably driven by increased trade with China, during which time interest rates and inflation both stayed around zero. Therefore, though falling private savings rates might not fit with the basic Eggertsson & Woodford (2003) liquidity trap model, it is not yet known if this would present a puzzle for an expanded, generalized model.

But that aside, here is really my fundamental issue. In a standard Woodford New Keynesian model, we know how long recessions can be expected to last without policy intervention: less than 5 years. In the liquidity-trap models, the characteristic length of a recession without policy intervention is not clear. Do recessions always go away on their own in a liquidity trap model, or does the economy get stuck indefinitely in a "bad equilibrium"? And recessions do go away on their own, how long does that usually take? I think this question needs answering before liquidity-trap models become our mainstream, go-to intuition about how the macroeconomy works.

Eggertsson & Woodford (2003) include some impulse response graphs, and it definitely looks like the effect of a shock decays in less than 5 years, just like in a standard Woodford New Keynesian model. However, those impulse responses are conditional on a policy regime that may not match what we see in real life. So the answer to the question of "How persistent are demand shocks in a liquidity trap model?" remains unanswered.

If it turns out that DSGE liquidity trap models don't produce stable "bad equilibria" or very very persistent impulse responses to demand shocks, then explaining Japan's 20-year-stagnation with one of these models will require the assumption of a whole string of negative shocks...just like their mainstream New Keynesian and RBC cousins.

So to sum up: No, I did not forget about the liquidity trap. And I kind of like the liquidity trap idea. I think liquidity traps are a candidate explanation for how demand shocks might have extremely long-lasting effects. But I do not know enough about the models to say that Japan's unusual situation can be explained by demand shocks + a liquidity trap. If the models require a long string of exogenous, hard-to-observe negative demand shocks in order to produce what we've seen in Japan, then I'm going to be very very skeptical. If, on the other hand, the models give some reason why some special Japanese characteristics - Shrinking population? Stagnant productivity? High levels of "patience"? - make a 20-year response to a single big demand shock a conceivable reality, then count me as a (tentative) believer.


Update: Steve Williamson and Matthew Martin both chime in with good posts that play around with the implications of liquidity-trap New Keynesian models. Both posts show how little of the standard New Keynesian intuition applies with liquidity traps, and how little we understand about the true general behavior of these models.

Update 2: Someone also reminded me of this paper by Mertens & Ravn, who find that liquidity trap models can sometimes cause supply and demand factors to become entangled, just as people like Tyler Cowen, Scott Sumner, and I have intuitively suspected in the case of Japan. The paper also shows, yet again, how many things we are still learning about the general behavior of the models, and their sensitivity to different assumptions and situations.

Japan's stagnation: demand-side or supply-side?

How should macroeconomists think about Japan's stagnation? By far the most popular and dominant view of the way macroeconomies work is the monetarist view popularized by Milton Friedman and formalized in DSGE models by Mike Woodford, Greg Mankiw, Guillermo Calvo, Jordi Gali, and other "New Keynesians". This view is so commonplace that many have internalized it.

A quick review for the uninitiated: In this view, the economy's performance consists of short-term "fluctuations" around a long-term "trend". The fluctuations are caused by "demand-side" factors like monetary policy and financial disturbances, while the "trend" is caused by "supply-side" factors like technology, gains from trade, taxes, and institutions.

In the New Keynesian models, which now mostly dominate the core of business cycle research, the demand-side effects come from sticky prices, including sticky wages. (This is not the only way you can get demand-side effects; inattention can get very similar results.) Once the sticky prices have had time to adjust, the economy returns to trend. In most New Keynesian models, the parameter that represents the time that it takes for prices to adjust is the "Calvo parameter". The smaller the Calvo parameter, the longer it takes demand shortfalls to go away on their own. The "short run" is the time during which prices have trouble adjusting; the "long run" is when they've had time to adjust.

In a New Keynesian model, when there is a demand shortfall, unemployment is the result. The central bank can print money in order to combat the shortfall, which raises inflation and lowers unemployment. But if the central bank does nothing, prices will eventually adjust, and unemployment will go away. This New Keynesian model corresponds nicely to the simple AD-AS model that people learn in Econ 102.

Is this kind of model the right way to think about Japan?

At first glance, it would seem that it is. After all, many of the people supporting Abenomics think that expansionary monetary policy will boost the real economy. That naturally suggests a mainstream, New Keynesian model or simple AD-AS model. Here, just for an example, is Nick Rowe thinking about Japan in the context of that sort of model.

But in order for monetary easing (the "first arrow" of Abenomics) to be the optimal policy in a New Keynesian world, the problem has to be an aggregate demand shortfall. And there are two reasons to think that this may not be what is happening to Japan. First of all, an aggregate demand shock should cause deflation (or disinflation) for only a short time. But Japan's deflation/disinflation has been going on for twenty years straight:



Presumably, prices and wages are able to adjust in 20 years' time. So an aggregate demand shock, even one as big as the bursting of the Japanese bubble in 1990, should not last nearly this long.

And there is the question of whether Japanese wages and prices are even particularly sticky in the first place. Here are Japanese wages:



Wage growth is sharply negative in some years, indicating that Japanese wages may not be so sticky. See also here. (Compare this to the U.S., where wages failed to fall much even during the big recent recession.)

So how can we be looking at a sticky-price story for Japan's stagnation? Well, we could be looking at a very long series of negative demand shocks. Japan could have just kept getting hit with shock after shock, giving the appearance of a long steady decline. But what were those shocks? If they were global in nature (such as the Asian financial crisis, the tech bubble, etc.), there's the question of why other countries around the world haven't mirrored Japan's deflationary experience. And a long string of negative domestic demand shocks is not in evidence.

It seems to me that the standard New Keynesian sticky-price story just cannot explain Japan. The "short run" for Japan is over and done. We are not looking at a "short-run" fluctuation caused by sticky prices.

This has implications for policy. It means that we can't expect the "first arrow" of Abenomics - quantitative easing - to boost the real economy through the kind of channel described by a New Keynesian or AD-AS model. It might do so through some other channel, but how exactly that will work is not clear.

What about the supply-side? Is Japan living in an RBC world? Well, it's true that Japan's total factor productivity has flatlined since the early 90s. Here's a not-quite-up-to-date graph from Hoshi & Kashyap (2011), but recent years have not looked any better:



This could suggest an RBC-style story of institutions and regulation choking off productivity growth (which is, in fact, the story Hoshi and Kashyap tell).

Also, Japan's labor hours per employed person have been in secular decline for about the same amount of time:



This suggests that Japan's stagnation could be partly caused by people deciding to work less - not necessarily a bad thing in a nation infamous for overwork. Instead of a "great vacation", call it a "great coffee break".

But I don't think Japan is living in an RBC world either. Because in an RBC world, keeping interest rates at zero for decades, and printing a bunch of money (as the Bank of Japan did in the mid-2000s), should cause inflation (without helping growth). Instead, we see persistent deflation. So an RBC model of the common type can't be describing Japan's world either.

So what sort of model is Japan living in? I'm not sure I know any model that describes Japan; maybe we don't have one. But my guess is that it's a world in which "Aggregate Demand" and "Aggregate Supply" are not as distinct entities as they are in Econ 102. In an AD-AS framework, either the AD curve or one of the AS curves shifts on its own. But in Japan, it may be that what look like supply shocks (falling productivity) and what look like demand shocks (deflation) may actually be due to the same cause.

And whatever world Japan is living in may have multiple equilibria. It may be that Japan is trapped in a "bad equilibrium", and it will require a "big push" to kick it back to the "good equilibrium". In fact, that seems to me to be the implicit premise of Abenomics.

In any case, we shouldn't be thinking about Japan solely in terms of our standard textbook models. The real world appears to be much weirder than those toy environments.


Update: Paul Krugman says zombies have eaten my brain:

Yes, in a standard AS-AD or NK model, high unemployment leads to falling wages and prices, and this eventually restores full employment... 

[But]the only reason deflation “works” in the standard model is that it increases the real money supply, which leads to lower interest rates; in effect, it acts like an expansionary monetary policy... 

But Japan has been in a liquidity trap during the whole period Smith looks at. Monetary expansion is ineffective unless it can raise expectations of future inflation. Deflation is definitely not going to help. In fact, by raising the real burden of debt, it makes things worse... 

A corollary is that while sticky wages are a real phenomenon...They are not, repeat NOT the reason either Japan or we have failed to recover.

But this doesn't really contradict what I was saying in this post. Just like Krugman says, a standard AD-AS or New Keynesian model would imply that Japan's deflation would have gone away on its own long before now. That was my point. So I'm not sure zombies have eaten my brain. (Then again, with no brain left, how is one to know?)

Now let's talk about liquidity-trap models. The story that Krugman tells - debt-deflation keeping price adjustments from clearing markets - is intuitively plausible (to me, anyway). I freely admit that I have not worked through a liquidity trap model in sufficient detail to know all the ins and outs of how one works. In one of these models - for example, Eggertson & Krugman (2011) - are there multiple equilibria? Is it possible for a negative shock to push a country into a bad liquidity-trap equilibrium, out of which it cannot escape unless it receives a big "kick" (from policy or from a positive exogenous shock)?

If so, then liquidity-trap models of the Krugman type are a candidate for the "multiple equilibria" story that I said I think is necessary in order to explain Japan's stagnation as a demand-side phenomenon. If liquidity-trap models are the replacement we need for textbook AD-AS and New Keynesian models, then economists and the general public need to thoroughly revise the intuition that we use to think about recessions.

But if liquidity-trap models do not contain multiple stable equilibria, then the length of Japan's deflation needs a different explanation. Frighteningly, the answer may depend on whether the model is linearized or not. (Note: It would also be easier to answer if I could find a set of impulse response graphs for a liquidity-trap model. But I can't find one...)

(Note that though I haven't worked through the details of an Eggertsson-Krugman type model, I do know other modified New Keynesian models that include a "bad equilibrium". One of these is a model by Miles Kimball and Bob Barsky, which they have not yet published online as a working paper. They should get around to doing that!)

Update 2: Ikeda Nobuo, Japan's most widely read econ blogger, responds (in Japanese), attributing Japan's stagnation to a long-term sectoral shift. Shades of Joe Stiglitz.

Update 3: Steve Williamson chimes in, chiding me for equating AD-AS with a standard New Keynesian model, and discussing liquidity traps with some simple graphs.