Macro Models and the Long Run

I was just looking at this working paper on the OECD’s new global macro model. What it is, is a set of equations relating a dozen or so macro aggregates for each major country or region in the OECD, at a quarterly timescale. OK, that sounds stupid and naive to economists, and hopelessly cryptic to everyone else. Let’s proceed. Some observations, first on structure, second on content. On form:
The equations comes in two flavors, long-term and short-term. Salient fact about the long-term ones is that most of them are imposed (singly or jointly) rather than estimated. For instance, the elasticities of consumption with respect to income and wealth are constrained to sum to one. The elasticity of employment with respect to real wages is constrained to be negative one. (Oh, that one makes me mad.) The elasticities of exports and imports with respect to their respective market sizes are constrained to be one. And so on. Meanwhile, the short-term (one- and two-year) equations are allowed to be determined by the data.

There’s a couple reasons for this, at least one of which is reasonable. The reasonable one is that they want the long-run behavior of the model to converge to an equilibrium. If, let’s say, the long-run elasticity of imports with respect to income was anything but 1, the share of imports in consumption would rise without limit over time. I’m not sure how I feel about this. (Bad blogger!) On the one hand, it’s obviously true that that imports or consumption relative to GDP, or the wage share, or relative prices among trading patterns, don’t diverge to infinity. On the other hand, time doesn’t pass to infinity either. The practical relevance of the long-run conditions is only for a period long enough that exogenous fluctuations have canceled out, yet short enough that the parameters of the model remain unchanged. It’s not at all clear to me that the set of such periods is not empty. On the other hand, there may be reasons why postulating a long-run equilibrium is useful, even if we recognize that no such equilibrium is ever reached.

The other reason for the long-run restrictions is less defensible — or, since really who cares about my opinion, let’s say it’s substantive rather than methodological. The model “combines short-term Keynesian-type dynamics with a consistent neoclassical supply-side in the long run.” (Interestingly, mainstream macro has this in common with a major strand of Marxist economics, in contrast with the (post-)Keynesians who allow a role for demand even in the long run.) So some of the long-run restrictions are imposed not simply to get an equilibrium, but to get a particular, tastes-endowments-and-technology equilibrium. There’s no reason in principle that practical macroeconomics should exclude the possibility of changes in real wages changing income shares in the long run. That the OECD does, tells you something.

On to the substance:

A couple interesting things here, which unlike the thumbsucking above, one can actually use. These are hardly gospel, of course; but enshrined in the OECD macro model they can be taken as stylized facts, in the sense that in many contexts they don’t, qualitatively, have to be explicitly argued for.
1. Wealth effects (on consumption) are largest for the US, smallest for Japan.
2. The effect of import prices on the domestic price level is negligible in the US and Japan, but substantial in Europe.
3. Trade flows are much more responsive to income changes than to relative prices. Estimated export elasticities are two to three times higher for income than for “competitiveness” [3]; estimated import elasticities are two to four times higher.
4. US export prices move with domestic prices essentially one for one; US import prices move with foreign prices only slightly. For most other countries, export pass-through is lower and import pass-through is greater.

The last two are particularly interesting.

Eventually, one would like to think through the conceptual basis, and limits, of these sorts of models. There’s that never-realized long-term. Meanwhile here in the short-term, when you’re making heterodox arguments it’s nice to get empirical backup from some place impeccably orthodox.

What is Keynesianism?

[A bit of thumbsucking inspired by discussion here.]

As a policy of countercyclical demand management, Keynesianism is based on the idea that there are no automatic forces in industrial capitalism that reliably equilibrate aggregate supply and aggregate demand. In the absence of government stabilization policies, the economy will waver between inflationary periods of excess demand and depressed periods of inadequate demand. The main explanation for this instability is that private investment depends on long-term profitability expectations, but since aspects of the future relevant to profitability are fundamentally uncertain [1], these expectations are unanchored and conventional, inevitably subject to large collective shifts independent of current “fundamentals”. Government spending can stabilize demand if G+I varies less over the business cycle than I alone does. For which it’s sufficient that government spending be large. It’s even better if G and I move in opposite directions, but the reason Minsky answered No to Can “It” Happen Again? was because of big government as such, not countercyclical fiscal policy.The focus on cyclical stabilization assumes that there is no systematic long-term divergence between aggregate supply and aggregate demand. But Keynes believed that there was a secular tendency toward stagnation in advanced capitalist economies, so that maintaining full employment meant not just using public expenditure to stabilize private investment demand, but to incrementally replace it. Another way of looking at this is that the steady shift from small-scale to industrial production implies a growing weight of illiquid assets in the form of fixed capital. [2] There is not, however, any corresponding long-term increase in the demand of illiquid liabilities. If anything, the sociological patterns of capitalism point the other way, as industrial dynasties whose social existence was linked to particular enterprises have been steadily replaced by rentiers. [3] The whole line of financial innovations from the first joint-stock companies to the recent securitization boom have been attempts to bridge this gap. But this requires ever-deepening financialization, with all the social waste and instability that implies. It’s the government’s ability to issue liabilities backed by the whole economic output that makes it uniquely able to satisfy the demands of wealth-holders for liquid assets. In the functional finance tradition going back to Lerner, modern states do not possess a budget constraint in the same way households or firms do. Public borrowing has nothing to do with “funding” spending, it’s all about how much government debt the authorities want the banking system to hold. If the demand for safe, liquid assets rises secularly over time, so should government borrowing.From this point of view, one important source of the recent financial crisis was the surpluses of the 1990s, and insufficient borrowing by the US government in general. By restricting the supply of Treasuries, this excessive fiscal restraint spurred the creation of private sector substitutes purporting to offer similar liquidity properties, in the form of various asset-backed securities. (Here is a respectable mainstream guy making essentially this argument. [4]) But these new financial assets remained at bottom claims on specific illiquid real assets and their liquidity remained vulnerable to shifts in (expectations of) the value of those assets. The response to the crisis in 2008 then consists of the Fed retroactively correcting the undersupply of government liabilities by engaging in a wholesale swap of public for private liabilities, leaving banks (and liquidity-demanding wealth owners) holding government liabilities instead of private financial assets. The increase in public debt wasn’t an unfortunate side-effect of the solution to the financial crisis, it was the solution. Along the same lines, I sometimes wonder how much the huge proportion of government debt on bank balance sheets — 75 percent of assets in 1945 vs. 1.5 percent in 2005)contributed to the financial stability of the immediate postwar era. With that many safe assets sloshing around, it didn’t take financial engineering or speculative bubbles to convince banks to hold claims on fixed capital and housing. But as the supply of government debt has dwindled the inducements to hold other assets have had to grow increasingly garish. From which I conclude that ever-increasing government deficits may in fact be better Keynesianism – theoretically, historically and pragmatically – than countercyclical demand management.
[1] Davidson, Shackle, etc. would say nonergodic. This strand of Post Keynesian thinking often wanders beyond my comfort zone.[2] This shift is ongoing, not just historical — not only do capital-output ratios continue to rise in manufacturing, but we’re seeing the “industrialization” of retail, health care, etc.

[3] Schumpeter is the only major economist to give sufficient attention to the sociology of the capitalist class, IMO. Marx’s insistence that the capitalist is simply the human representative of capital is a powerful analytic tool for many purposes, but it leaves some important questions unasked.

[4] Here is another.

What’s wrong with macroeconomics

Really, you could start anywhere.

But let’s take this, from VoxEU:

In a recent paper (Laibson and Mollerstrom forthcoming), my co-author David Laibson and I make further attempts to assess whether the saving glut hypothesis fits with reality. We build a model where one country (the US) receives exogenous capital inflows which are calibrated to match the US current account deficits for the period that Bernanke was focusing on. Our model shows us that such a course of events should indeed lead to increases in US consumption. However, we also find that the investment rate should have risen by at least 4% of GDP. Intuitively this makes sense; if the Chinese government exogenously loaned US households a trillion dollars, those US households should have chosen to invest a substantial share of those funds to help make the interest payments.

What’s missing here? Businesses, one, and the financial system, two. Investment decisions are supposed to be made directly by households. Of course writers like this (a grad student and professor at Harvard, natch) know that firms and banks exist; they just assume that there are no important differences between an economy with them and one without them — the standard approach, despite its seeming self-refuting quality, to macroeconomics today. This will seem trivially obvious to anyone who’s taken a macro course, and astonishing to almost anyone who hasn’t; it’s still a bit astonishing to me. It’s nice to be reminded, though, of why post-Keynesian and Marxist approaches to macroeconomics are still essential.