Links for October 14

Now we are making progress. This piece by CEA chair Jason Furman on “the new view” of fiscal policy seems like a big step forward for mainstream policy debate. He goes further than anyone comparably prominent in rejecting the conventional macro-policy wisdom of the past 30 years. From where I’m sitting, the piece advances beyond the left edge of the current mainstream discussion in at least three ways.

First, it abandons the idea of zero interest rates as a special state of exception and accepts the idea of fiscal policy as a routine tool of macroeconomic stabilization. Reading stuff like this, or like SF Fed President John Williams saying that fiscal policy should be “a first responder to recessions,” one suspects that the post-1980s consensus that stabilization should be left to the central banks may be gone for good. Second, it directly takes on the idea that elected governments are inherently biased toward stimulus and have to be institutionally restrained from overexpansionary policy. This idea — back up with some arguments about  the“time-inconsistency” of policy that don’t really make sense — has remained a commonplace no matter how much real-world policy seems to lean the other way. It’s striking, for instance, to see someone like Simon Wren-Lewis rail against “the austerity con” in his public writing, and yet in his academic work take it as an unquestioned premise that elected governments suffer from “deficit bias.” So it’s good to see Furman challenge this assumption head-on.

The third step forward is the recognition that the long-run evolution of the debt ratio depends on GDP growth and interest rates as well as on the fiscal balance. Some on the left will criticize his assumption that the debt ratio is something policy should be worried about at all — here the new view has not yet broken decisively with the old view; I might have some criticisms of him on this point myself. But it’s very important to point out, as he does, that “changes in the debt ratio depend on two factors: the difference between the interest rate and the growth rate… and the primary balance… The larger the debt is, the more changes in r – g dwarf the primary balance in the determination of debt dynamics.” (Emphasis added.) The implication here is that the “fiscal space” metaphor is backward — if the debt ratio is a target for policy, then a higher current ratio means you should focus more on growth, and that responsibility for the “sustainability” of the debt rests more with the monetary authority than the fiscal authority. Admittedly Furman doesn’t follow this logic as far as Arjun and I do in our paper, but it’s significant progress to foreground the fact the debt ratio has both a numerator and a denominator.

If you’re doubting whether there’s anything really new here, just compare this piece with what his CEA chair predecessor Christina Romer was saying a decade ago — you couldn’t ask for a clearer statement of what Furman now rejects as “the old view.” It’s also, incidentally, a sign of how far policy discussions — both new view and old view — are from academic macro. DSGE models and their associated analytic apparatus don’t have even a walk-on part here. I think left critics of economics are too quick to assume that there is a tight link — a link at all, really — between orthodox theory and orthodox policy.


Why do stock exchanges exist? I really enjoyed this John Cochrane post on volume and information in financial markets. The puzzle, as he says, is why there is so much trading — indeed, why there is any trading at all. Life cycle and risk preference motivations could support, at best, a minute fraction of the trading we see; but information trading — the overwhelming bulk of actual trading — has winners and losers. As Cochrane puts it:

all trading — any deviation of portfolios from the value-weighted market index — is zero sum. Informed traders do not make money from us passive investors, they make money from other traders. It is not a puzzle that informed traders trade and make money. The deep puzzle is why the uninformed trade, when they could do better by indexing. …

Stock exchanges exist to support information trading. The theory of finance predicts that stock exchanges, the central institution it studies, the central source of our data, should not exist. The tiny amounts of trading you can generate for life cycle or other reasons could all easily be handled at a bank. All of the smart students I sent to Wall Street for 20 years went to participate in something that my theory said should not exist.

At first glance this might seem like one of those “puzzles” beloved of economists, where you describe some real-world phenomena in terms of a toy model of someone maximizing something, and then treat the fact that it doesn’t work very well as a surprising fact about the world rather than an unsurprising fact about your description. But in this case, the puzzle seems real; the relevant assumptions apply in financial markets in a way they don’t elsewhere.

I like that Cochrane makes no claim to have a solution to the puzzle — the choice to accept ignorance rather than grab onto the first plausible answer is, arguably, the starting point for scientific thought and certainly something economists could use more of. (One doesn’t have to accept the suggestion that if we have no idea what social needs, if any, are met by financial markets, or if there is too much trading or too little, that that’s an argument against regulation.) And I like the attention to what actual traders do (and say they do), which is quite different from what’s in the models.


Yes, we know it’s not a “real” Nobel. So the Nobel went to Hart and Holmstrom. Useful introductions to their work are here and here. Their work is on contract theory: Why do people make complex ongoing agreements with each other, instead of just buying the things they want? This might seem like one of those pseudo-puzzles — as Sanjay Reddy notes on Twitter, the question only makes sense if you take economists’ ideal world as your starting point. There’s a whole genre of this stuff: Take some phenomenon we are familiar with from everyday life, or that has been described by other social scientists, and show that it can also exist in a world of exchange between rational monads. Even at its best, this can come across like a guy who learns to, I don’t know, play Stairway to Heaven with a set of spoons. Yes, getting the notes out takes real skill, and it doesn’t sound bad, but it’s not clear why you would play it that way if you weren’t for some reason already committed to the gimmick. Or in this case, it’s not clear what we learn from translating a description of actual employment contracts into the language of intertemporal optimization; the process requires as an input all the relevant facts about the phenomenon it claims to explain. What’s the point, unless you are for some already committed to ignoring any facts about the world not expressed in the formalism of economics? This work — I admit I don’t know it well — also makes me uncomfortable with the way it seems to veer opportunistically between descriptive and prescriptive. Is this about how actual contracts really are optimal given information constraints and so on, or is it about how optimal contracts should be written? Anyway, here’s a more positive assessment from Mark Thoma.


Still far from full employment. Heres’ a helpful report from the Center for Economics and Policy Research on the state of the labor market. They look at a bunch of alternatives to the conventional unemployment rate and find that all of them show a weaker labor market than in 2006-2007. Hopefully the Clinton administration and/or some Democrats in the Senate will  put some sharp questions to FOMC appointees over the next few years about whether they think the Fed as fulfilled its employmnet mandate, and on what basis. They’ll find some useful ammunition here.


Saving, investment and the natural rate. Here’s a new paper from Lance Taylor taking another swipe at the pinata of the “natural rate”. Taylor points out that if the “natural” interest rate simply means the interest rate at which aggregate demand equals potential output (even setting aside questions about how we measure potential), the concept doesn’t make much sense. If we look at the various flows of spending on goods and services by sector and purpose, we can certainly identify flows that are more or less responsive to interest rates; but there is no reason to think that interest rate changes are the main driver of changes in spending, or that “the” interest rate that balances spending and potential at a given moment is particularly stable or represents any kind of fundamental parameters of the economy. Even less can we think of the “natural” rate as balancing saving and investment, because, among other reasons, “saving” is dwarfed by the financial flows between and within sectors. Taylor also takes Keynes to task (rightly, in my view) for setting us on the wrong track with assumption that households save and “entrepreneurs” invest, when in fact most of the saving in the national accounts takes place within the corporate sector.


On other blogs, other wonders:

At Vox, another reminder that the rise in wealth relative to income that Piketty documents is mainly about the rising value of existing assets, not the savings-and-accumulation process he talks about in his formal models.

Also at Vox: How much did Germany benefit from debt forgiveness after World War II? (A lot.) EDIT: Also here.

Is there really a “global pivot” toward more expansionary fiscal policy? The IMF and Morgan Stanley both say no.

Another one for the short-termism file: Here’s an empirical paper suggesting that when banks become publicly traded, their management starts responding to short-run movements in their stock, taking on more risk as a result.

Matias Vernengo has a new paper on Raul Prebisch’s thought on business cycles and growth. Prebisch would be near the top of my list of twentieth century economists who deserve more attention than they get.

I was just at Verso for the release party for Peter Frase’s new book Four Futures, based on his widely-read Jacobin piece. I don’t really agree with Peter’s views on this — I don’t see the full replacement of human labor by machines as the logical endpoint of either the historical development of capitalism or a socialist political project — but he makes a strong case. If the robot future is something you’re thinking about, you should definitely buy the book.


EDIT: Two I meant to include, and forgot:

David Glasner has a follow-up post on the inconsistency of rational expectations with the “shocks” and comparative statics they usually share models with. It’s probably not worth beating this particular dead horse too much more, but one more inconsistency. As I can testify first-hand, at most macroeconomic journals, “lacks microfoundations” is sufficient reason to reject a paper. But this requirement is suspended as soon as you call something a “shock,” even though technology, the markup, etc. are forms of behavior just as much as economic quantities or prices are. (This is also one of Paul Romer’s points.)

And speaking of people named Romer, David and and Christina Romer have a new working paper on US monetary policy in the 1950s. It’s a helpful paper — it’s always worthwhile to reframe abstract, universal questions as concrete historical ones — but also very orthodox in its conclusions. The Fed did a good job in the 1950s, in their view, because it focused single-mindedly on price stability, and was willing to raise rates in response to low unemployment even before inflation started rising. This is a good example of the disconnect between the academic mainstream and the policy mainstream that I mentioned above. It’s perfectly possible to defend orthodoxy macroeconomic policy without any commitment to, or use of, orthodox macroeconomic theory.


EDIT: Edited to remove embarrassing confusion of Romers.

12 thoughts on “Links for October 14

  1. According to the proponents of “helicopter money,” governments are predisposed towards *tight* fiscal policy – which is why central banks need to be given fiscal powers. How’s that for time inconsistency?

  2. To nitpick this sentence:

    It’s also, incidentally, a sign of how far policy discussions — both new view and old view — are from academic macro.

    I think you mean to say “theoretical” macro, not the more broad “academic”. Much of what is driving this shift of opinion has been the explosion of empirical work demonstrating the efficacy of fiscal policy.

    1. That’s a fair point. Altho I have to admit I wonder how much the empirical work is following rather than leading the shift in opinion.

  3. Macrofoundations, too, are defective
    Comment on J. W. Mason and Lance Taylor on ‘Saving, investment and the natural rate’

    J. W. Mason gives a summary of Lance Taylor’s recent paper* without realizing that Lance Taylor continues the tradition of messing up the saving-investment issue.

    Lance Taylor asks: “Today’s New ‘Keynesians’ have tremendous intellectual firepower. The puzzle is why they revert to Wicksell on loanable funds and the natural rate while ignoring Keynes’s innovations.”*

    Lance Taylor’s answer consists in a conspiracy hypothesis: “Wicksell and Keynes planted red herrings for future economists by concentrating on household saving and business investment.”

    Reality is much simpler, economists produce false theories because they are scientifically incompetent. The loanable funds theory is a case in point.

    Roughly speaking, the loanable funds theory says that saving and investment are equalized by the interest rate mechanism, which is a variant of standard supply-demand-equilibrium. What economists have not realized until this day is that all three elements of the general market model (supply function, demand function, equilibrium) are NONENTITIES. This means that the Wicksellian model has already been dead in the cradle. However, as the saying goes: “The difficulty lies, not in the new ideas, but in escaping from the old ones …”. This applies to Walrasians AND Keynesians.

    Keynes formulated the formal core of the General Theory as follows: “Income = value of output = consumption + investment. Saving = income – consumption. Therefore saving = investment.”

    This elementary syllogism is conceptually and logically defective because Keynes never came to grips with profit (Tómasson et al., 2010).**

    Let this sink in: Keynes had NO idea of the fundamental concepts of economics, that is, of profit and income. His error/mistake carried over to National Accounting.*** Therefore, it is NO surprise at all that loanable funds macro models do not fit the data.

    The correct profit equation for the investment economy reads: Qm=Yd+I-Sm. Legend Qm: monetary profit, Yd: distributed profit, Sm: monetary saving, I: investment expenditures. The profit equation gets a bit longer when government and foreign trade is included.

    The difference between investment and saving I-Sm plus distributed profit Yd determines monetary profit Qm for the economy as a whole. Saving is NEVER equal to investment, neither ex ante nor ex post, and there is NO mechanism to equalize them, that is, NO such thing as supply-demand-equilibrium. The whole discussion about whether the Wicksellian interest rate mechanism or the Keynesian income mechanism establishes the equality/equilibrium of saving and investment is entirely vacuous. Because of this, the discussion about monetary and fiscal policy NEVER had a sound scientific foundation.

    To conclude:

    (i) All I=S/IS-LM models from Keynes/Hicks to the present are provable false.

    (ii) The loanable funds/natural interest rate theory is provable false.

    (iii) The classical and Keynesian profit theories are provable false.

    (iv) The representative economist has not gotten (i) to (iii) since 80 years.**** This includes J. W. Mason and Lance Taylor.

    Egmont Kakarot-Handtke

    * See ‘The ‘Natural’ Interest Rate and Secular Stagnation: Loanable Funds Macro Models Don’t Fit the Data’

    ** See post ‘How Keynes got macro wrong and Allais got it right’

    *** See paper ‘The Common Error of Common Sense: An Essential Rectification of the Accounting Approach’

    **** For more enlightment see cross-references

    1. The representative economist has not gotten (i) to (iii) since 80 years.**** This includes J. W. Mason and Lance Taylor.

      At least I’m in good company!

  4. Re contract theory. In defense of formal economic theory, it has one big advantage it is logically coherent, and it provides a solid basis for conversation.

    I just read a rightly well-regarded lawyer’s book addressing a crucial economic topic, and the mess this very intelligent professor made of the discussion was remarkable. He switched from (implicit) general equilibrium analysis to partial equilibrium analysis without even realizing what he was doing. Thus having implicitly imposed a zero-profit condition he started discussing how a policy would increase the firm’s profits.

    Formal analysis may be deeply flawed because it is so far removed from the subject of discussion. But informal analysis is just as deeply flawed. I vote for we need both.

    1. Fair enough. I was thinking of including a line to the effect that even if describing contracts in the language of economics doesn’t in itself tell us anything we didn’t already know, it may be a foundation for looking at concrete reality in a more productive way.

  5. Sorry, but your Romer confusion reminds me of a joke told by Paul Romer, maybe 20 years ago. And I am going to stink up your comments section telling it.

    P Romer claims he was at a conference on stage with C Romer and observed during a Q&A that he did not have an opinion on a budgetary issue because it was not his speciality. Somebody in the audience said, well why don’t you just ask your wife right there.

    Oh, my wife doesn’t know anything about economics.

    Be doom boom.

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