Nouriel Roubini (Doctor Doom)

According to CNBC (First in Business Worldwide):

Global markets have rallied "too much, too soon, too fast" this year but a
correction will not happen right away, as a cheap dollar will still encourage investors to seek higher-yielding assets for a few more months, leading economist Nouriel Roubini said Thursday. Roubini, one of the few economists who accurately predicted the
magnitude of the financial crisis, said the U.S. dollar will eventually recover some of its losses, but only in "six to 12 months from now, not any time soon."

I have nothing against Roubini; doomsayers are a dime a dozen (see my previous post). What I find incredible is how professional columnists at self-proclaimed "leading business networks" mindlessly genuflect at the alter of stopped clocks.

You've heard the old joke about how economists have successfully predicted 10 out of the last 2 recessions. Eric Tyson has a nice little piece claiming that Roubini is among these tireless prognosticators; see here. That's right, Roubini called the recession in 2004, 2005, 2006 and in 2007. As the old saying goes, even a stopped clock is correct twice a day. The puzzle is why there is such a large and persistent demand for stopped clocks.

A History of Hysteria

An interesting recurring fact of human history is the endless supply of doomsayers. One would think that this large supply would drive the price (wages) of these prophets of doom to zero. But from Isaiah to Al Gore, we see that this is not so. We are left to conclude one of two things: either economic theory is wrong; or there exists a large persistent demand for doom and gloom. Naturally, I prefer the latter interpretation. But if so, then evidently, we like having the shit scared out of us. I'm not sure why this is the case, but if so, the phenomenon deserves study.

Most of you are likely too young to remember the hysteria created by the Club of Rome in their 1972 report The Limits to Growth. Not sure what ever happened to these bozos.

I remember my grade 3 teacher announcing to my class that at current rates of air pollution, the world was destined to run out of oxygen in 10 years (1980). I spent the rest of that afternoon trying to design an oxygen tent that might save my family from this impending disaster. Today, I'm sure that students would be well-versed in the technique of sequestering government "stimulus money" to finance the endeavor.

But then my attention was turned to a more pressing issue: the coming ice age; see Newsweek 1975 The Cooling World. Back then, meterologists (aka the experts) were convinced that the globe was cooling; and that disaster loomed on the short horizon. While no one was sure of what was causing the cooling trend, there was a strong suspicion that industrialization (aka capitalism run amok) had something to do with it. All that pollution blocking the sun's rays; and so on.

Fortunately, we didn't have to worry about global cooling for long; it was soon supplanted by a much more pressing concern: Acid Rain. The culprit? You guessed it: industrialization. Never heard of acid rain? Don't worry about it.

The latest, of course, is global warming...oops, I mean "Climate Change." The climate changing...imagine that. The culprit? Do I even have to ask?

How are we to understand all of this? H.L. Menken had this to say:"The whole aim of practical politics is to keep the populace alarmed (and hence clamorous to be led to safety) by menacing it with an endless series of hobgoblins, all of them imaginary."

One of my colleagues (Charles Crawford) had this to say: "Why is there such zeal for belief in global warming? I think that it taps into many different sources of the desire for power. Some think it will allow regulation of the evil capitalist system. Others see opportunities for new capitalist opportunities. Some feel it will put a crimp in the style of rising economics, such as China. Others with Puritan sentiments find it satisfying. It would be interesting to explore the desires for power that encourage belief in global warming."

Another one of my colleagues (John Heaney) offers this: "Guilt, as a feeling merited or unmerited, reduces a natural inclination to oppose bogus authority. It is amazing that more or less random unwarranted associations suffices to produce this feeling with effect.Climate justice, climate debt, climate reparations, climate colonialism.Almost certainly, these slogans, will be the permanent legacy of Copenhagen. So why worry about the science?"

I like this letter to the editor of the Economist Magazine, Dec 12, 2009 by Paul Reiter: "Sir-- Passion is the root problem in what you term 'the modern argument over climate change'. ('A heated debate', November 28th). You state for instance, that the 'majority of the world's scientists have convinced themselves' that human activity is the cause of climate change. I know of no poll that confirms this, but your choice of words is telling. In science, our interpretations of nature are based on observation, experiment and evidence, not self-conviction. Those of us who are dismissed, often derided, as sceptics have waited a long time for the chicanery behind the global-warming movement to come to light. But we should not blame scientists --however unprincipled--nor UN organizations, nor national governments. The true culprits are latter-day Nostradamuses, who, under their icons of cuddly pandas and polar bears, have misused science to stoke fear, guilt and a craving for atonement in the minds of the public. Governments have been browbeaten to respond to these catastophists, and some scientists, dependent on public money, have fashioned their behaviour accordingly. Nikolay Semyonov, a Soviet scientist and Nobel prize winner in chemistry, wrote that: 'There is nothing more dangerous than blind passion in science. This is a direct path to unjustified self-confidence, to loss of self-cricalness, to scientific fanatacism, to false science. Given support from someone in power, it can lead to suppression of true science, and since science is now a matter of state importance, to inflicting great injury on the country.' Semyonov was referring to the ruthless manipulation of Soviet science by Trofim Lysenko and other opportunists. In a similar vein, it is time we recognize that we are becoming prey to a new fanaticism, a religious fervour that runs contrary to rational society."

Leigh Palmer notes that "It should be noted that Paul Reiter (of the Pasteur Institute in Paris) is a respected scientist and a former lead author for the IPCC assessments. He left the process and had his name removed as an author because the IPCC had published scientific misinformation regarding malaria in the second and third assessment reports. He had quite a battle with the officials of the IPCC over this and his story bears listening to. You can hear him tell this story in his own words here. His story is not entirely unique, as other lead authors and lead reviewers* have resigned from the IPCC process for very similar reasons.The IPCC has a mission. It was formed by the UN pursuant to the United Nations Framework Convention on Climate Change to gather evidence linking anthropogenic atmospheric carbon dioxide to harmful effects on the world's human population. In effect the IPCC is a prosecutor in a criminal proceeding with copious resources at its command to prove carbon dioxide guilty. The prosecutorial metaphor fails, however, because there is no institutional defense. Carbon dioxide is being tried by a modern Inquisition."

I am inclined to agree with these assessments. Not that this makes me feel any better. I think we can all agree that we would prefer to live in a cleaner world; and that it is desirable that society takes steps toward meeting this worthy goal. Why do many influential people feel the need to resort to scare tactics and bullying to achieve this goal (assuming that this is their goal)? And why do so many of us fall for it, time and time again?

PS. Just came across this fun read: History's Hysteria

Climate Science Hanky Panky

The scientific community is buzzing over thousands of emails and documents -- posted on the Internet last week after being hacked from a prominent climate-change research center -- that some say raise ethical questions about a group of scientists who contend humans are responsible for global warming. Read more here: WSJ

Interesting development: Phil Jones, Director of the Climate Research Unit at University of East Anglia, is stepping down pending an investigation into the ethical conduct of his and perhaps other climate scientists' work on historical global temperature research; see here.

And now for something truly appalling (I sincerely hope that this is not true): Uh Oh -- Raw Data in New Zealand Tells a Different Story than the Official One.

An interesting piece in today's WSJ: The Climate Science Isn't Settled (by Richard S. Lindzen, professor of meteorology at MIT). See also: Climategate.

Thank goodness that the science of macroeconomics is settled and free of any politically-motivated hanky panky!

Fiscal Multipliers in War and in Peace

It truly is breathtaking how certain some people are of what they know to be true about the way a macroeconomy operates. The Krugmans and DeLongs of this world really make it sound like everything we really need to know has been settled long ago. Yes, the science is "settled" (where have we heard this before?).

I recently came across this piece by Brad DeLong: A Guide for the Perplexed. Consider the following quote:

But when fiscal boost was tried on a large enough scale, it certainly did the job. And it is reasonable to infer (with all the caveats provided by the CBO) that what is true in the very large will be true in the merely large as well. Eugene Fama says that it is theoretically impossible for fiscal stimulus to boost output: World War II proves him wrong. Robert Barro says that the multiplier is zero: World War II proves him wrong. Benn Steil says that Jacques Rueff in 1947 conclusively proved that fiscal policy could not boost employment: World War II proves him wrong.

Implication: a WWII style fiscal stimulus will "do the job" in a peacetime recession. WWII "proves" it. Egad...how does he know this? Why do I not feel as confident that this is the case? Am I truly that dense? (an invite to some rather rude comments, I'm sure!)

In any case, I decided to gather my thoughts on the subject and post them here for public review and criticism. The piece is a bit too long for a blog posting; so if you're interested, please click here. Looking forward to any comments.

I Don't Mean to Nitpick, But...

You have no doubt read the news. The WSJ headline reads: Economy Snaps Long Slump, GDP's 3.5% Rise May Mark End of Recession; Recovery Weak, Reliant on Stimulus. See here. I reproduce their figure at the right.

Evidently, consumer spending "led" third-quarter growth (note the implicit use of the theory that consumer spending "drives" growth -- it is hard to get reporters to think outside the Econ 101 box). The 1% figure is, I think, rightly attributed in part to the "cash for clunkers" program.

My nitpick is the following observation. Almost all of these expenditure components (save exports) consists of spending on both domestically produced goods and imports. What fraction of this 1% is accounted for by spending on imported motor vehicles and parts?

It would be more informative, I think, if all these expenditure components had imports subtracted off individually; rather that summing them all up and then subtracting off total imports (the -2% figure in red).

Given the way the numbers are presented here, we have no idea to what extent the government subsidy stimulated domestic production (which is what goes into the calculation of GDP), as opposed to total expenditure. In short, did the "cash for clunkers" program simply encourage Americans to purchase foreign vehicles; and, if so, to what extent might one argue that this program encouraged the domestic production of vehicles (as opposed to foreign production)?

Averting the Worst

According to Paul Krugman, we recently avoided a Great Depression because of Big Government; see here.

By any "reasonable" estimate, he says that the current stimulus program has saved up to 1 million jobs. Let's imagine that this is true. According to the government's own figures (see here), roughly 100 billion of the stimulus plan has been spent to date (the vast majority in the form of transfers; rather than purchases). So, if my arithmetic is correct, this translates into only $100,000 per job. Well done, government.

The thing that caught my eye in Krugman's piece was this statement:

All of this [Big Government not slashing spending the way the private sector does during recession] has helped support the economy in its time of need, in a way that didn't happen back in 1930, when federal spending was a much smaller percentage of GDP.

He is, of course correct in stating that the U.S. federal government was much smaller in 1930. And while he does not say so explicitly, I think he may leave the reader with the additional impression that, in addition to being small, the Hoover government actually chose to become smaller (mimicking the private sector in tightening its belt through hard times). The facts, as far as I can gather, seem to suggest something quite different.

According to this data, government outlays from 1930-33 increased by 9.0%, 19.4% and 46.5%, respectively. The latter two years in particular constituted classic deficit-financed expansionary policy (a policy, one might add, came under scathing criticism for recklessness by the Democratics in Congress, led by Roosevelt himself).

I'm not sure what to make of such data; but it does seem to dispell the myth of Hoover as a "do nothing" president.

It is of some interest, I think, to record how the economy recovered from recession prior to the era of Big Government. I seem to recall a fairly significant recession occurring in the early 1920s. Here is the data.
According to this data, the economy contracted by 3.3% and 4.3% in 1920 and 1921, respectively. The economy expanded by 4.5% and 11.4% in 1922 and 1923, respectively.

How did it manage this recovery after 2 years in the absence of Big Government? Why did a Great Depression not occur?

In fact, fiscal policy throughout this entire episode was significantly contractionary. How are we to make sense of this? Or, more precisely, I wonder how Krugman would make sense of this?

[Thanks to Doug Smith, for gathering this data]

And the New Minneapolis Fed President is...

Narayana Kocherlakota; see here.

Hmm...his biography says that he was born in Baltimore. I seem to recall him mentioning that he was born in Winnipeg. Is he Canadian, or isn't he? Someone enlighten me!

In any case, he is an excellent choice. NK is a consummate academic: clear-thinking, articulate, and persuasive. Does he have what it takes to be a successful/influential Fed president? Yes, I believe so. Apart from his academic credentials, he has a very easy manner; not many people are likely to find him a boor. He has the gift of skewering lame-brained ideas to the wall, and then making you feel good that you've learned something useful (at least, this has been my experience).

Congratulations to NK...and good luck!

Kocherlakota on the State of Macro

A very nice piece by NK here. Unfortunately, you won't see something like this published in the NYT. But naturally, we can rely on DeLong to make a comment; see here: Narayana Leaves Me Puzzled. I love this classicly stupid DeLong quote:

The models thus tell us that downturns are either the result of a great forgetting of technological and organizational knowledge, a great vacation as workers develop a sudden extra taste for leisure, or a great rusting as the speed with which oxygen in the air corrodes speeds up and so reduces the value of large things made out of metal.

This is exactly how I would expect a first-year undergraduate to interpret a model that they've seen for the first time. And DeLong claims that he has a PhD in economics! Let me help the poor lad along.

Modern macro models now incorporate "news shocks." A news shock is the random arrival of information that leads people to (rationally) revise their forecasts of future events. These forecasts may be made, for example, over future productivity, future riskiness of investments, future policies, etc. These news shocks do not seem like an implausible impulse mechanism; unexpected news arrives every day.

Investment demand today depends on forecasted productivity of investment. These forecasts will change with news; leading to variations in investment that an econometrician might identify as "aggregate demand shocks." As the investment matures and comes online, its actual productivity may be higher or lower than originally forecast; its realization constitutes another "shock."

There is no need to appeal to DeLong's childish "great forgetting" interpretation of a negative technology shock. A negative technology shock occurs when the expected return on investment is lower than expected. The return on an important class of investments may turn out to be terrible (think of all the fibre optic cable planted across the world's oceans in anticipation of a demand that never materialized). And as Fisher Black has stressed, these types of errors are typically correlated across agents. In short, recessions may be explained, in part, by collective mistakes on investments made in the past.

In any case, what DeLong fails to offer us what he might propose instead as the ultimate source of the business cycle? I am guessing that he might say something like "animal spirits." So why did the recession occur? Because people thought that it would. Why did that boom occur? Because people believed that it would.

There may be an element of truth to the animal spirit hypothesis; but then, there do appear to be competing interpretations as well. If DeLong would spend less time writing his blog and more time reading the literature, he might one day be less puzzled with Narayana's observations.

Levine to Krugman: A Love Letter

David Levine (Washington University in St. Louis) writes an open letter to Paul Krugman here.

Thar she blows! The Bitter Paul Krugman

The latest by Paul Krugman here: How Did Economists Get It So Wrong?

So what, pray tell, have we learned from the blowhard this time?

First thing: Krugman is not an economist. Evidence: Throughout his long rant, he is careful in referring to economists as "they." So whatever went wrong, please don't blame Krugman. On the other hand, not being an economist does not appear to place limits on his profound knowledge of how the profession should reorganize its thinking. Please show us the way, o wise one.

But first, what went wrong exactly? His claim is that the profession fell in love with its mathematically elegant models; and adopted a belief that unfettered markets achieve the best of all possible worlds (Dr. Pangloss). Evidently, this latter belief, supported by unsubstantiated modeling, translated into policy advice with predictable consequences.

Funny though: My reading of economic history suggests that economic crisis preceded mathematical modeling. Moreover, the phenomenon seems to transcend institutional regime (economic crises are endemic to "planned" societies as well). And as for how the philosophy of free market capitalism has manifested itself in reality--well, this is utterly laughable.

In any case, his claim that "Freshwater economists are, essentially, neoclassical purists" is so far off the mark as to make one question his academic credentials. The neoclassical framework is certainly viewed as a benchmark; but almost all serious work that I am aware of regularly departs from its basic tenets (in particular, by explicitly modeling the problems that arise when commitment is limited and information is private). There is, in fact, much work being done in taking institutions seriously, in modeling environments where trade is subject to search frictions, and in identifying potentially beneficial policy interventions. Krugman would not be aware of this, of course, as he spends all his time writing op-ed pieces for the NYT instead of actually engaging in difficult research questions.

It is true, however, that most of the profession adopts the view that individuals are "rational;" at least, in the sense that we model people trying to the best they can (according to a well-defined objective) subject to the constraints imposed upon them by the economic or institutional environment. I believe that this assumption is employed for three reasons: [1] the idea that people try to do the best they can subject to limitations does not sound crazy; [2] the hypothesis admits all sorts of "crazy" equilibrium behavior anyway; and [3] it is hard to know what the hypothesis should be replaced with. In particular, while there is only one way to be "rational," there are an infinitely many different ways to be "irrational."

To give you just two quick examples, Krugman offers his Capitol Hill Babysitting Cooperative anecdote as some sort of puzzle for "neoclassical" economists. I doubt, however, whether he has read this. Or, if you believe his rant the mathematically inclined are oblivious to possibility of economic catastrophe; read this.

As an alternative, Krugman proposes the methodology of behavioral finance. Basically, the approach there is to simply assume that people behave according to some (theoretically imposed or empirically estimated) rule of thumb. In less polite language, assume that people are "stupid." Personally, I believe there may be much to be learned by this approach; and I welcome the fact that a part of the profession devotes some time exploring its implications. But one gets the sense that Krugman prefers this approach because by adopting it, we admit that the general population is stupid and is therefore in need of guidance. This guidance, quite naturally, is to come from self-appointed philosopher kings, like Krugman (consulting $).

On one point, Krugman is correct: There was a growing complacency among many in the profession (and elsewhere). He is incorrect, however, in suggesting that this complacency was the product of economists falling in love with their mathematical models. The majority of the profession continues to whittle away at difficult problems in relative obscurity. The complacency, in my view, stemmed from people like Krugman -- people who poo-poo those of the profession engaged in exploring difficult problems in a rigorous manner.

Krugman prefers his simple equations--an IS curve, and LM curve, and all his "fudge factors" to explain the world. Not much else is needed when you know that the world is stupid; and that you alone hold the answers.

Unfortunately, people are evidently too stupid even to recognize Krugman's genius (confirming his hypothesis in his own mind, no doubt). Is this the source of his thinly-disguised bitterness?

Fiscal Multiplier Mockery

Just came across this IMF Staff Position Note by Olivier Blanchard (and coauthors) entitled Fiscal Policy for the Crisis.

The best part of this paper is contained in Appendix II: Fiscal Multipliers-A Review of the Literature, and Appendix III: Five Case Studies of Fiscal Policy During Financial Crisis.

The conclusion I arrive at in reading these appendices is that during a financial crisis: [1] fixing the financial sector is of primary importance; and [2] fiscal policies may be marginally beneficial at best, and seriously detrimental at worst.

In the body of the paper, the authors draw several lessons from history.

[1] Successful resolution of the financial crisis is a precondition for achieving sustained growth.

Here, they give the example of Japan during the 1990s. Evidently, "fiscal actions following the bursting asset bubble failed to achieve sustained recovery because financial problems were allowed to fester."

In short, fiscal stimulus failed in Japan. But we don't really want to believe that fiscal stimulus doesn't work. It didn't work here because things were not set up to allow it to work. I wonder how one might modify an IS-LM model to formalize this notion?

But there are more examples. "Delaying interventions, as was also done in the US during the Hoover administration and during the S&L crisis, typically leads to a worsening of macroeconomic conditions, resulting in higher fiscal costs later on."

So I guess that if we wait too long, the fiscal multiplier now is severely negative. Not sure what to make of this (like, where does this show up in the IS-LM model?). And in any case, they have their history wrong: Hoover did in fact react quickly to the crisis (although many of his measures were frequently blocked by the Democrats-Roosevelt, in particular-and then later adopted wholesale by the Democrats). And even though "interventions" were evidently delayed during the S&L crisis, I seem to recall a fairly protacted spell of growth in the 1980s. Unimportant details, I suppose.

Ah yes, but there was the "prompt and sizeable support to the financial sector by the Korean authorities that limited the duration of the macroeconomic consequences thus limiting the need for other fiscal action."

Huh? The Korean government fixed the financial sector, thereby eliminating the need for future fiscal stimulus? So fiscal stimulus is not needed, if the financial sector is repaired. This is supposed to be taken as evidence that fiscal stimulus is needed?

[2] The solution to the financial crisis always precedes the solution to the macroeconomic crisis.

Sure.

[3] A fiscal stimulus is highly useful (almost necessary) when the financial crisis spills over to the corporate and household sectors.

Not sure where this came from; they cite no examples (and indeed, the examples above seem to suggest otherwise).

[4] The fiscal response can have a larger effect on aggregate demand if its composition takes into account the specific features of the crisis.

In this regard, they note that the tax/transfer policies implemented early in the Nordic crisis did little to stimulate output. Sure, the Ricardian equivalence theorem at work. As for "evidence" as to how a different composition of expenditure might work, they make the following compelling statement: "In theory, public spending on goods and services has larger multiplier effects..."

I see. That would be the same theory (IS-LM) that has absolutely nothing to say about financial crisis?

And so, on the basis of this, the authors' conclusions are:

The optimal fiscal package should be timely, large, lasting, diversified, contingent, collective, and sustainable: timely, because the need for action is immediate; large, because the current and expected decrease in private demand is exceptionally large; lasting because the downturn will last for some time; diversified because of the unusual degree of uncertainty associated with any single measure; contingent, because the need to reduce the perceived probability of another “Great Depression” requires a commitment to do more, if needed;collective, since each country that has fiscal space should contribute; and sustainable, so as not to lead to a debt
explosion and adverse reactions of financial markets.

And so there you have it. The fiscal multiplier is greater than one. Unless, that is, the stimulus in question is any one of: not-in-time, small, short, undiversified, non-contingent, non-collective, and unsustainable.

Why the Growing Level of U.S. Debt May Not be Inflationary

History shows that high levels of government debt are frequently associated with inflation. The reason for this seems clear enough. At some point, maturing debt needs to paid back. At high enough levels of debt, rolling the debt over is no longer feasible. Cutting back government spending and raising taxes is politically difficult. The easy way out is simply to print new money. As the money supply expands, inflation resuts.

The rough logic described above would seem to fit the experience of many smaller economies that find themselves under fiscal pressure. But things may not work so simply for a select few dominant economies. Japan appears to be one example; and the U.S. another.

Let us consider the U.S. Unlike most other economies, there appears to be a huge worldwide demand for U.S. Treasuries and U.S. dollars (which can be thought of as zero-interest Treasuries). A large scale increase in the supply of these government debt instruments need not lead to a depreciate in their value if there is a correspondingly large scale increase in the worldwide demand for these objects. What is the evidence that this may be happening?

Foreigners Snap Up Treasuries Even as US Debt Keeps Rising

But why should this be so? What accounts for what appears to be an insatiable demand for US debt, especially in the wake of the recent financial crisis?

Ricardo Caballero of MIT offers some hints in a very interesting piece entitled: On the Macroeconomics of Asset Shortages. After reading this paper, I started thinking in the following way. Tell me what you think.

There is a high and growing demand for low-risk assets, both as a store of value, and as collateral objects in payment systems (e.g., repo and credit derivatives markets). This growth has exploded over the last 20 years or so; and stems from the demand from emerging economies and innovations in the financial sector. There is a worldwide "shortage" of good quality (low-risk) assets, like U.S. Treasuries (which explains their relatively low yield). Indeed, many of the innovations in the financial sector can be interpreted as the private sector's response to this shortage: the creation of "low-risk" tranches of MBSs allowing these objects to substitute for U.S. Treasuries as collateral in the rapidly expanding repo market.

The recent financial crisis was centered in the repo market. Very suddenly, agents in the repo market were no longer willing to accept MBS as collateral (or if they did, at very large "haircuts"). The demand for U.S. Treasuries exploded (I seem to recall a day when their yields actually went negative). At the same time, there was a worldwide "flight to quality;" which again, manifested itself as large increase in the demand for (relatively safe) U.S. Treasuries.

If this is more or less true, then the implication is this: The massive increase in the supply U.S. Treasury debt may very be "socially optimal" in the sense that the U.S. government is simply supplying the world with an asset that is in very high demand (which, in turn, means that the demanders obvious find some value in the existence of such an asset). To the extent that this "new demand regime" remains stable, the added supply of U.S. Treasuries will impose no financial burden on the U.S. (indeed, they make off like bandits, as the Treasuries are ultimately purchased by exporting goods and services to the U.S.).

The million dollar question, of course, is whether the high world demand for U.S. debt will persist long into the future (and whether the U.S. government will "overissue" debt beyond what is called for by this new high-demand regime). Who knows what will happen. But it appears to me that IF the U.S. government plays its cards right, it may very well enjoy its higher debt levels without the prospect of inflation. U.S. citizens will benefit (from the sales of Treasuries for goods) and the world will be grateful to hold a stable asset.

Well, maybe. But that was a big IF. What could possibly go wrong?

William Poole on Ben Bernanke

For those of you who may not know, I have recently joined the Federal Reserve Bank of St. Louis as a VP in the research division. Will keep you posted on things that I learn (and am allowed to reveal).

We were recently asked to comment on an article written by Bill Poole, former president and CEO of the Fed here in St. Louis. He asks the question: Should President Obama reappoint Fed Chairman Bernanke? See here. His conclusion is "no." (too late, it appears).

So what's his beef? Essentially, that some of the new policies initiated by Bernanke have violated stipulations in the Federal Reserve Act (FRA) and that, in doing so, he has comprised the Fed's political independence. The relevant stipulations are section 13(3) and section 14(b).

Poole grants Bernanke some leeway in terms of the emergency measures adopted in March 2008 (Bear Stearns) and September 2008 (AIG). But he believes that the Fed's Commercial Paper Funding Facility (CPFF) violates section 13(3). He may have a point here; but there is not much a leg for him to stand on as the term "exigent" is not precisely defined.

Poole also believes that the Fed's buying program for Mortgage Backed Securities (MBS) is not authorized under Section 14(b). I beg to differ. As far as I can tell, the act does allow for purchases of assets that are guaranteed by the U.S. government. The MBS purchased by the Fed are fully insured by the Treasury (and indeed, they are generating a very nice return).

Poole makes some very good points about distancing the Fed from politics as much as possible. But I do not believe that he makes a compelling case against reappointment. Among other things, he does not propose alternative candidates (many of the apparent frontrunners would likely view Bernanke's interventions as too conservative). Bill should be careful what he wishes for.

In any case, it looks like Bernanke will be reappointed (after a good grilling in front of the Senate). Considering the alternatives, I think this was the right choice.

Why is Brad DeLong Such a Twit?

News Flash: Brad DeLong finds Bob Lucas "annoying;" see here.

Naturally, DeLong is entitled to his opinion; and I'm sure that he sometimes makes some good points (as in, even a blind squirrel finds the odd nut). But exactly what point was he trying to make with a blog entry entitled "Oh Why Can't We Have Better Nobel Laureates in Economics?"

Who does he have in mind as a better laureate, exactly? Himself, perhaps? Here is a second rate historian with an Econ 101 toolkit dissing one of the great economists of his generation. And for what, pray tell?

Lucas claims that there is widespread disappointment with economists because we did not forecast or prevent the financial crisis of 2008. He goes on to say

Macroeconomists in particular were caricatured as a lost generation educated in the use of valueless, even harmful, mathematical models, an education that made them incapable of conducting sensible economic policy. I think this caricature is nonsense and of no value in thinking about the larger questions: What can the public reasonably expect of specialists in these areas, and how well has it been served by them in the current crisis?

Good question. People are likely to have different views on this. An invitation for debate.

DeLong does not appear interested in addressing the question. Instead, he brilliantly points out that there were economists who predicted recent events; and the source of public disappointment is that economists did not listen to these correct forecasts! Well, not that anyone actually forecasting anything with precision...here is what he says:

It is true that no model is going to successfully forecast the time and date of a "sudden fall in the value of financial assets." But that misses the point. What Mussa and his posse correctly did was forecast the growing size of the left-side tail of the distribution of possible future financial asset changes.

Let me see if I understand. Regular economists were simply cautioning that there was risk of financial disruption; say 5% (or some number consistent with historical norms). A financial crisis occurs...and this proves regular economists to be bad forecasters. They did not see the "increasing risk" like others. Mussa and other were better forecasters because their risk estimates were higher.

Two weathermen make a forecast: One predicts precipitation with 10% probability and the other with 20% probability. The rain comes...and Brad DeLong would claim that the latter is a better forecaster than the former.

Thanks Bradley. A word of advice: Don't stay up at night waiting for the Nobel prize.

Religiosity in Macroeconomics and the Sad Case of Father Wilder

A booming economy suddenly grinds to a halt. Stock prices are plummeting, wealth evaporating, investors fleeing to safe assets, consumer and investment spending contracting, deflationary forces appearing evident, banks and other businesses failing, employment falling, and unemployment rising. The forecast is for a long recession; possibly even a depression. What is to be done?

Gosh...I'm not really sure. Naturally, and like most people, I have some opinions on what sort of policy responses are more likely to work than others. My opinions on this question have evolved over the last 20 years. I interpret this process as learning (or unlearning, in some cases). I've learned a lot of new theories; theories that have opened my eyes to how any given set of observations might interpreted in wildly different, yet plausible, ways. I've also learned something about the history of similar (yet each in their own way, distinct) economic events. Nevertheless, I remain very ignorant; there is still much to learn. I expect that my opinions--or my belief system, if you prefer--will continue to evolve in the light of new theory and evidence.

Recently, I've become interested in the theory of religion. I'm not even sure yet how one might usefully define the term. I have something like the following in mind: "An unshakable belief in some preconceived notion." Formally, one might begin by saying that a person has some prior belief b that A is true; where b is between 0 and 1. This belief may evolve over time according to some learning algorithm, b' = B(b,e), where b' is a posterior belief, updated from a prior belief b, and new information e. I like to think of B(.) as Bayes' rule; but other learning algorithms are possible as well.

I define a person to be religious along dimension A if b=0 or b=1. Now, one interesting thing about Bayes' rule is that b' = b if b = 0 or b = 1. In other words, a Bayesian who begins with an absolute certain prior (one way or the other) will hold on to an unshakable belief (will not learn from any new information). We are all likely religious, in this sense, along at least some dimensions. If we are, then we might do well in recognizing the phenomenon when it occurs and at least be honest enough to own up to it.

On to some macroeconomics. In reply to the question posed above, imagine that someone proposes policy A; where A = a large fiscal stimulus policy is socially desirable in the event of an economic "crisis" as described above.

Now, if you would have asked my opinion on policy A several years ago, I think I might have assigned belief b = 3/4 that A is true. Given what I know today (which is still not very much), I would assign something closer to b = 1/4. In short, I would say that policy A is likely to fail. My good friend, Nick Rowe of Carleton University, expresses an opinion that is closer to b = 3/4. He believes that such a policy is likely to succeed. While we both have very different opinions, we each acknowledge that we really do not know for sure. That is, we are not religious on this matter.

Such differences of opinion are quite natural. The differences can likely be accounted for by the fact that both Nick and I have been exposed to different theories, have read different historical accounts of past crises, and have generally had different personal experiences that, together, have led our beliefs to follow different paths. But because we are not religious, and because we recognize this is so, we find it fruitful to persuade each other (and in the process, ourselves) on the validity of our beliefs. This is, I think, the best we can probably hope for in any science.

This all leads up to the topic of religion in macroeconomics. This field, more than any other it seems, appears to populated by true believers who like to view themselves as priests of some sort. One sure way to identify a priest is in how "exasperated" they become when failing to gain converts on the basis of what they know to be an "obvious" truth. Take Bruce (Father) Wilder for example. He knows that b = 1 when it comes to policy A.

Father Wilder, I have a confession to make.
What is it, son?
I'm not sure that hell exists.
What?! This is blasphemy!
So hell exists?
Most certainly!
And how do you know?
Poor, wretched and miserable child!
Um, yeah...OK. But really, how do you know?
It is obvious, you cursed flea-brain; the Bible says so!
Forgive me father, but there appear to be some inconsistencies in the Bible...
You are damned, child...you must endeavor to dismount the fortress of your conceit!
Maybe you can help me, Father...just a little bit of evidence...please?
Volcanoes.
Volcanoes?
The flames of Satan himself! Are you blind?
I'm not sure, Father...I have heard that volcanoes might be plausibly explained in some other manner.
How dare you question my authority!?
Sorry! I'm sorry I asked! Yes, I see it now...volcanoes. Got it.

I now direct you to Father Wilder and his volcanoes here.

Can fiscal stimulus spending increase aggregate output and employment? Yes.

Um, OK. But this was not the question. Even in the simple static labor-leisure model, output can be made to increase with an increase in G. We know this, you dope. We also know from history that conscripted labor can achieve the same result. But the associated increase in (measured) GDP is not necessarily welfare-improving (although it could be for certain individuals or sectors). What evidence can you bring to bear that a fiscal stimulus actually worked in a time of crisis?

Is there good evidence that this is the case? Yes. What is this good evidence? Well, pretty much the whole history of macroeconomic fluctuations in output and employment is evidence in favor of fiscal stimulus "working" in this positive "mechanical" sense.

If you say so, Father Wilder. Can you show me some evidence...please? Show me, so that I too may be saved from the flames of damnation!

Every year, employment increases with the seasonal rise in Xmas retail sales, and that fluctuation in output and employment is evidence that the economy works in a way that makes fiscal stimulus spending effective in increasing aggregate output and employment (when output is low relative to capacity and unemployment is high).

Volcanoes?! Father, I too am aware that GDP drops by about 90% every night; and there are frequently two consecutive periods (called weekends) in which GDP drops by a similar amount. I am also aware that seasonal fluctuations are huge. Having worked in the construction sector myself for many years, I know what cold weather can do to productivity. I am aware of the boom in expenditure that accompanies seasonal sales. I also know that these fluctuations can all be easily explained by a simple labor-leisure model with time-varying shocks to productivity and preferences. How is this relevant for understanding how fiscal stimulus is likely to mitigate what happens during an economic crisis? I hate repeating myself, but is there any evidence that you might bring to bear on this question?

Every business cycle provides plentiful evidence that rising aggregate spending drives increased output and employment. That kind of aggregate fluctuation kind of defines the business cycle. In the U.S. historical experience, two prime applications of fiscal stimulus as policy, inadvertently in WWII and deliberately during the Kennedy-Johnson Administration, certainly demonstrate increases in aggregate output and reductions in unemployment and chronic poverty. If you want to, you can find plenty of evidence in regional fluctuations as well -- the effect, for example, of the Reagan defense spending increases on Boston's Route 128 were pretty dramatic.

(The man must be hard of reading). Regional fluctuations? I already admitted the case in favor of helping out depressed sectors or regions. I am talking aggregate here. I am not talking about WW2 or the 1960s. I am talking about severe (non-war) economic crises, like the one we're currently experiencing, and like those experienced in history. (And the idea that aggregate spending "drives" the economy is an hypothesis, not a fact. You are confusing correlation with causation).

Let me try to help you out, Father Wilder. One legitimate question that could have been raised is why I think b = 1/4. One piece of data that led me to revise this belief downward was the case of Japan; see, in particular,

This is annual data from the Penn World Tables; and I've talked about it before here. The blue line measures real per capita GDP in Japan relative to that of the U.S. The red line measures the (G/Y) ratio in Japan, relative to that in the U.S. The blue and red lines are virtual mirror images of each other. In particular, note how late in the sample, the relatively expansionary fiscal stimulus in Japan is associated with a relative decline in their GDP.

Now, this is a rather interesting diagram, I think. Doesn't prove a damn thing of course. But it should lead one, I would think, to step back a moment and ponder the validity of b = 1.

Different interpretations are possible. One is that the data is lousy and hence conveys no useful information (so that prior beliefs may remain unchanged). I have some sympathy for this view. Another view is that the large fiscal stimulus in Japan may indeed have worked; in the sense that absent any stimulus, the blue line would have plummeted far more than it did. Yes, this is a possibility; although I wonder how many people might find it persuasive? The other interpretation, of course, is that the fiscal stimulus did not actually work at all; and in fact, likely made things much worse. This may or may not be true, but it certainly does not sound crazy to me. Certainly not crazy enough to deserve the pompous and pretentious sermons of an exasperated preacher trying to convince someone otherwise.

So, I am done asking the same question over and over again to Father Wilder. But I would like to direct this question to others. I am almost certain that one of you can come up with some data over some relevant time period for some crisis episode that might lead me to revise my belief in the other direction. I am very curious to see what the data looks like for the 1930s (a cross-country sample would be desirable).

Bruce Wilder on Andolfatto

Some time ago, I posed a question to those who were advocating "fiscal stimulus" in the form of increasing government spending as a weapon to combat a recession that typically follows a financial market panic. The question was: What evidence can you bring to bear that would persuade an agnostic that "fiscal stimulus" has "worked" in the past? ("Worked" in the sense of leading to a desirable increase in aggregate output and employment).

I have yet to receive what I consider to be a satisfactory answer to this question. I have, however, received a considerable number of responses that appear to be based on three basic principles hardwired into peoples' heads: [1] Econ 101 teaches us that increase in G leads to increase in Y; [2] Private markets are screwed up (and government agencies are not); and [3] Evidence that an increase in G leads to an increase in Y based on some wartime episodes.

In a nutshell, these people believe that: [1] leaves them with a firm theoretical foundation; that [2] legitimizes their belief in the principle of government intervention; and that [3] supports their view on the practical and desirable consequences of such intervention. In the language of climate alarmists, it is "obvious" that the "science is settled."

And what sort of response is in store for those who dare question [1]-[3]? Here is an example of Bruce Wilder comments on my earlier post. (Note: I have no idea who Bruce Wilder is, but I am pretty sure he cannot be an economist).

Libertarianism -- in all its mindless glory -- is often less a political philosophy than it is a personal conceit, a pose of intellectual superiority coupled with a demand that others assault one's own tower of skepticism, and, should one choose not to surrender, those assaulting will be found wanting. Much of what follows, in Andolfatto's posting, suggests that he can be as dense as a box of rocks. I just find him exasperating.

Now, I confess that I can be a rather slow learner. And maybe I am as dense as a box of rocks. But I am also being sincere in my question (and I have been known to change my mind in the past). Mr. Wilder's response to this question is basically this: How Dare You Ask Such a Question, You Mindless and Conceited Fool? I am reminded of the response by Brian's mother (Monty Python's Life of Brian) when she was asked whether she was a virgin or not.

Luckily, Andy Harless, a commenter plays the part of the voice of reason: "It seems to me that the burden of proof is on those who say that fiscal spending doesn't work. As you note, the visible evidence suggests that it works: the roads and bridges get built; there are many people looking for work, some of whom can presumably be employed to build those roads and bridges. If you want to argue about the general equilibrium effects, present a model in which those do erase the advantage of the stimulus, and someone else will present a model in which they don't. Then we can test the two empirically. Since, as your responders noted, there is econometric evidence which suggests that the government spending multiplier is greater than one, I'm guessing that the empirical analysis will tend to reject your model."

Ah, sweet reason. Somehow, I doubt that Harless will be judged to have penetrated the libertarian fortress of Andolfatto's conceit, at least by Andolfatto.

Actually, I thought that Andy Harless provided a thoughtful reply. I did, however, find his response wanting. According to Mr. Wilder, this should be construed as being attributable to the libertarian fortress of my conceit. This guy sounds like your common schoolyard bully (I suspect that he is more like the little Wizard of Oz).

My response to Andy Harless' reply is as follows:

[1] Yes, I did admit that there is ample evidence which suggests that fiscal stimulus "works" at the microeconomic or sectoral level. I even suggested that such a policy may desirable from the perspective of providing a form of social insurance to those who work in particularly hard hit sectors. But this is a far cry from saying that such a policy will work at the aggregate level. When the government makes an appropriation of funds from the private sector, this money is no longer available for private use. There has to be some crowding out. How much crowding out is an empirical question. So what is the evidence that a large fiscal stimulus will "work" in an economic crisis?

[2] Yes, there have been some econometric studies which purport to show that the multiplier on government spending is greater than one. But there are also econometric studies that suggest something closer to zero. In any case, no one is likely to be persuaded one way or the other by the results reported from running regressions on simple linear and reduced-form representations of historical data. People are much more likely to be persuaded by actual and dramatic historical episodes where such a policy can plausibly be interpreted as "working." Can you give me a few historical examples where this has been the case?

[3] What we do know from history is this. During the panics that afflicted the U.S. during the National Banking Era (1863-1913), recessions were typically short and severe; and the economy recovered without fiscal stimulus. This was also true during the Swedish financial crisis in the early 1990s. The only two dramatic examples I can think of where a recession prolonged into a depression involved massive fiscal stimulus; like the U.S. during the Great Depression, and Japan during its "Lost Decade." Is this the type of evidence that people have in mind in favor of fiscal stimulus?

Mr. Wilder: Please forgive me for remaining skeptical. I wish that what seems "obvious" to you might be made to seem obvious to me too. I ask that you persuade me, not by challenging my intellect or calling me names, but providing me with some evidence in support of your religion.

B.C. Election Campaign 2009

There is something very important happening in BC at the moment. The Vancouver Canucks are in a death struggle with the Chicago Blackhawks (series tied 1-1). Things are not looking good as the series moves to Chicago. Game 3 is on tonight. Oh, the drama!

There is also something less important happening in BC at the moment. We are in the midst of a provincial election campaign. I heard that the provincial party leaders are engaged in a series of debates. Naturally, I checked out the comedy network for the full schedule. No luck. But I did find a summary here of some recent "highlights."

The cast of characters are in the finest tradition of BC politics (they are all nuts). But I think that NDP leader Carole James really takes the cake. Here is a quote:

"We’re doing that (lowering taxes, increasing spending) within a fiscally responsible plan, a balanced budget in four years, and putting you and your family first. That’s what people are looking for in these tough times.”

That's right: she will put you and your family first. The presumption, I suppose, is that the other leaders are promising to put you and your family second.

Ms. James' platform reminds me of the fabulously funny radio campaign put on by my favourite London hangout Joe Cools in the 1980s: "Come to Joe Cools...where we'll screw the other guy and pass the savings on to you!"

Relative to Ms. James, Mr. Cools is to be commended along three dimensions. First, Mr. Cools understands the concept of feasibility (it is impossible to put everyone first; unless, of course, everyone is simultaneously put last). Second, Mr. Cools is honest. And third, Mr. Cools was actually trying to be funny. I vote for Joe Cools!

Now...back to the NHL playoffs...

Against Intellectual Property

I have long suspected that there was something fishy about the economic defense for property rights in knowledge. My first attempt at questioning the wisdom of such a policy at a conference at NYU in 1994 was met with harsh criticism (especially from the late great Fisher Black, bless his libetarian soul). I was never able to fully recover from that experience, and so I meekly let that research program die.

But I am now very pleased to see that Michele Boldrin and David Levine have taken up the cause. Levine was kind enough to visit SFU on March 20, 2009 where he delivered a public lecture entitled "Against Intellectual Property." The lecture, if you are interested, is now available online here.

There is much food for thought here. The logic of his argument and the evidence he provides is quite persuasive, in my view. But if you see any holes in his arguments that have escaped me, please let me know.

Believing in Fiscal Stimulus 2

In part 1, I asked the question: Why do some people believe that fiscal stimulus "works" in the sense that it leads to a desirable increase in aggregate output and employment?

I have yet to see what I would consider to be a persuasive argument in favor of this belief.

Bruce Wilder (see his response to my earlier post) suggests that most economists do not believe that this is true universally; but that it is true only under "special" circumstances like a large negative "aggregate demand" shock. According to Bruce:

The case for fiscal stimulus rests on the belief that macroeconomic circumstances are such that the economy is not near, and is not headed in the near-term toward, a full-employment equilibrium, and that the price matrix is seriously out-of-whack.

I think that his view reflects accurately how many economists feel about why a massive fiscal stimulus is currently needed. The question I have for non-believers is the following: Do you find Bruce's argument persuasive?

Personally, I do not. He makes no attempt to justify his belief that the price-system is seriously out-of-whack. And even if it is out-of-whack, he makes no attempt to explain to us why this is the product of market malfunctioning, rather than government regulation. Moreover, he does not tell us what "the full-employment" level of employment is in the U.S. Nor does he identify other episodes in economic history where the policy has worked under similar "special" circumstances. No...instead we are asked simply to believe. Indeed, the non-believers are asked to explain why they do not believe!

I have stated earlier that I believe that fiscal stimulus can "work" as a redistributive mechanism. The only semi-clear evidence I see where fiscal policy has "worked" to stimulate aggregate output and employment is in the U.S. during WW2. But this policy was also associated with a significant decline in private consumption. In short, people were willing to make sacrifices to support the war effort. A similar policy today would not likely be viewed as welfare-enhancing by a population not currently facing a large threat to national security.

Where else can we find examples of economies subject to Bruce's special "deflationary" shock? How about Japan? Why did Bruce not mention the "success" that Japan has had in overcoming its troubles with fiscal stimulus. Let me explain to you why. Because the evidence clearly does not support the hypothesis; see my earlier post here. (Actually, if memory serves, perhaps Bruce mentioned that the Japanese case simply shows that fiscal stimulus is "not enough." But even so, this is hardly a persuasive argument to make in favor of fiscal stimulus).

But then, there are a lot of really smart people out there that believe that it works. Take Brad DeLong for example in his debate with Michele Boldrin; see my post here. DeLong, being the economic historian that he is, even goes so far to give us examples that purport to show why fiscal stimulus will work. What are his three examples? Here they are:

[1] The 2003-2005 housing boom, facilitated by loose monetary policy;[2] The 1996-1998 internet boom;[3] The post 1982 boom following the easing of monetary policy, the Reagan tax-cuts, and increase in military expenditure.

Now are you persuaded?

Perhaps we should believe on the basis of what some econometricians report to be fiscal multipliers above one? No one will be persuaded; this "evidence" is simply not compelling. (Among other things, we know that based on the manner in which fiscal purchases are accounted for in NIPA, the "true" contributions to GDP are by definition overstated).

Where is the evidence? Somebody please tell me. I need something more than a thinly-veiled belief that the private sector is screwed up and that therefore "something" must be done by the government to correct this screw-up.

Let me repeat what I have said in earlier posts: if a case is to be made for fiscal stimulus, it should likely be framed in terms of its desired effects as a redistributive mechanism. Here, I think the evidence is much clearer and can be made much more persuasive. One may question why it is socially desirable to keep construction workers or auto workers employed when there is clearly too much product on the market, but at least it is clear how such a policy benefits these unfortunate workers.

I suspect that this argument is not made for two reasons. The first is political; i.e., it is much more politically palatable to sell a fiscal stimulus package on the grounds that "everyone" will be made better off. The second has to do with the way most conventional macroeconomic models are structured; in particular, they are usually one-sector models so that economists trained in these models have not often thought about how, in practice, fiscal policy is usually directed to specific sectors. Who knows...this is largely conjecture on my part.

Believing in Fiscal Stimulus

My earlier post appears not to be having its desired effect. What I am really curious to know is why people believe that fiscal stimulus "works" in the conventional sense; i.e., leads to a desirable increase in aggregate output and employment.

Personally, I do not believe this; that is, I remain unconvinced by the arguments people typically employ to support this belief. This does not mean that I believe that the contrary is true; it simply means that I remain agnostic.

But most people appear not to be agnostic on the matter; they appear to believe very strongly that fiscal stimulus works. Of course, there are some that believe very strongly that the opposite is true. I am not sure what accounts for their belief either, but I choose to ignore them. The burden of the proof surely rests with those that believe. If you want me to make a big earthly investment in relation to your belief in Jesus Christ, then it is up to you to convince me (it is not up to me to disprove the existence of God).

When I was an undergrad, I believed that fiscal stimulus worked. Why did I believe this? Because this was what I was told; and at that young age, I had no reason not to believe what my professor told me. Moreover, he could show me the "logic" of the argument by way of a simple theory (at that time, the IS-LM model). He could even point to WW2 as empirical evidence in support of the theory. This theory was further corroborated in my mind by the fact that policymakers, newspaper columnists, and many other economists said exactly the same thing. The "truth" of this matter was (and still remains) conventional wisdom.

I also used to believe that Lemming populations were prone to commit mass suicide by jumping off cliffs. Why did I believe this? Because this is what I was told; in particular, this is what Walt Disney told me in his Academy Award winning 1958 documentary White Wilderness. You can see the footage here. How's this for empirical evidence?


Naturally, almost everyone who has ever heard of the phenomenon actually believes it. The image of lemmings running off a cliff has become a popular metaphor for following a crowd in an unthinking manner; see figure above.

It was only many years later that I discovered that this "fact" was a myth. Even worse, the "Norwegian" lemmings shot by Disney were imported from Hudson Bay to Calgary, where they did not jump off the cliff but were, in fact, launched off the cliff using a turntable.

I suppose that the point I am trying to make is that we are all to some extent "slaves of received wisdom." This is unavoidable. But it is not unavoidable that we should let this defect prevent us from questioning the conventional wisdom handed down to us by our predecessors (and repeated in rote-like fashion by true believers). I am wondering to what extent the widespread belief in fiscal stimulus is similar in any way to what many believe to be true of lemming populations?

As I mentioned in my earlier piece, many (certainly not all) people appear to believe in fiscal stimulus because they can see how it "works" at the microeconomic level. For example, here in my home province of British Columbia, we can measure quite directly the impact on gross employment stemming from the government's decision to build several state-of-the-art "fast ferries." The shipworkers benefited; as did a number of related trades. And the incomes earned by these people in this endeavor were no doubt spent in a manner that "stimulated" other economic activity.

But while the impact on gross employment is easy to measure, the impact on net employment is not. This particular fiscal stimulus program cost provincial taxpayers close to $500 million. This is 500 smackeroos that was no longer in the hands of the people who earned it. This loss of private sector purchasing power must have surely depressed the demand for all sorts of goods and services; and by implication, depressed the demand for labor in many sectors of the economy. Moreover, some of that income that would have been saved to ultimately finance other capital expenditures, now found its way to finance a fleet of fast ferries. In short, the aggregate impact of this policy--if measured correctly--is not likely to have been very large. (Unfortunately in this case, it did turn out to be large, but in the opposite direction; see fast ferry fiasco).

It would be more persuasive, in my view, if proponents of fiscal stimulus promoted their belief on the basis of its redistributive effects; not its aggregate effects. There may very well be a good reason to advocate fiscal stimulus with the view of supporting various sectors in dire need of help. But this is a very different argument than asserting that (almost) everyone will somehow benefit. This latter argument may even be true; but like I said, I have yet to be presented with convincing evidence.

Does Fiscal Spending "Work"?

I just returned from a visit to the Bank of Canada and had the opportunity to speak to a few high-level officials at the Bank along with several leading academics concerning a variety of issues relating to the current financial crisis.

In some of my conversations, I brought up the subject of fiscal spending; in particular, the desirability of many of the so-called "fiscal stimulus" packages that are currently being proposed. I am not sure why I was surprised, but almost everyone I spoke to thought that there was clear merit in the idea of "fiscal stimulus;" especially in the form of infrastructure investment.

Once their view was made known, I asked the question "why?" What evidence can be brought to bear in support of their view? What was it that convinced them of their belief on this matter?

Judging by the delay in the responses I received, I got the impression that many were not used to being asked such a question. They had to pause, after the initial shock I suppose, of having to collect their thoughts on the matter. The responses I received were not entirely convincing.

The responses could be divided into one of three categories:

[1] There is econometric evidence which suggests that the government spending multiplier is greater than one;
[2] The big jump in U.S. fiscal spending during WW2 and corresponding increase in GDP constitutes clear evidence of the efficacy of fiscal stimulus; and
[3] These are unusual times; the market is screwed up and *something* of this sort must be tried.

Personally, I am skeptical of having one's belief on the matter so firmly rooted on the basis of [1]. But perhaps one of you might persuade me otherwise.

The second world war is one data point that most people like to point to for confirming evidence. But is it wise to base one's beliefs on this one data point? The war experience was rather unusual. True, there was a massive buildup in military hardware (and hence, measured GDP), much of which was destined for destruction. But there was also a sharp drop in personal consumption expenditures (e.g., foodstuffs and material were rationed to the population). And while employment surged, much of this was by taking women out of the home sector and into the production of war materials. I can see why a population might want to make such sacrifices during a period of war; but would they be willing to do so today? And if so, would such a diversion of resources make society better off in any meaningful sense? I am not sure.

I found [3] the least convincing. My own view is that if we do not have convincing evidence that a particular policy will "work," then how do we know that doing "something" might not leave things even worse off than doing "nothing" at all? Since doing "something" involves the mass appropriation of resources from private citizens, would it not be better to err on the side of doing "nothing?" (Evidently not).

Of course, there may be better answers to the questions I asked, but these were the answers I received. My surprise, I suppose, was not in the answers themselves; but rather, how firmly people seemed to believe in the value of fiscal stimulus on the basis of their reported answers. Is this some sort of new religion? Perhaps they might have provided more convincing answers if they had a little more time to think about it, but I am not sure.

My own view is that people believe that fiscal stimulus works because there is no question that it does work at the microeconomic level. That is, when the government commissions a large number of workers to build something, one can actually see it being built, and one can actually see workers being employed in the act of construction.

But of course, what appears to work at the microeconomic level does not necessarily mean that it "works" at the macroeconomic level. It is harder to "see" the general equilibrium effects. It is harder to estimate net employment creation (rather than gross). What would these workers have been doing absent the government project? Would they have sat at home "idle;" or would they have been employed in some other sector (or perhaps engaged in retraining?). And how does the tax bill levied on the population at large affect their desired spending? If government spending is so successful in one area, then why not have the government coordinate all production activities in the economy? What is the optimal level of government spending? How does one calculate it? These are much harder questions to answer; and so, I suppose it is easier if they are not asked.

I leave you with a couple of articles on Japan's fiscal experience:
Bloated Bureaucracy Exposed (Japan Times)
Japan's Big-Works Stimulus is a Lesson (NY Times)

For the time-being, I remain agnostic on the subject (although, I confess that the evidence from Japan leans me more in one direction than the other). If someone can provide me with clear evidence one way or the other, I'd really appreciate it!

King Solomon's Dilemma and Behavioral Economics

When the tale of King Solomon's dilemma was first told to me as a kid, I was (like most people, no doubt) left marvelling at Solomon's brilliant solution to a rather difficult predicament.

But then I grew up and made the unfortunate choice of pursuing a graduate degree in economics. My mind was left rotted to the point where I could no longer appreciate what most other people continued to believe was the self-evident wisdom of Solomon.

The problem with Solomon's "solution" is that it adopts what in modern parlance would be labeled a "behavioral approach." In other words, the solution relies heavily on the assumption that people are "irrational" in a particular sense. It turns out to be easy to be a wise philosopher king when one assumes that everyone else is irrational. Perhaps this is why so many aspiring philosopher kings today want to replace conventional economic theory with what they call "behavioral economics."

Let's think about this. The "mechanism" (game) designed by Solomon proposes to split the baby in two (sounds "fair" at least). One women screams out "No! Let the other have the whole baby instead." The other woman coldly agrees to the solution. The real mother is revealed in the obvious manner. What is not so obvious is why the false mother could not have anticipated this outcome; a more clever woman would have simply mimicked the behavior of the true mother. Instead, the false mother fails to make this calculation (and instead adopts a simple "behavioral" strategy; which is just a fancy label for irrational behavior).

Now, perhaps there really are "irrational" people like the false mother. But would you be willing to stake a baby's life on this assumption? Even if this mechanism worked out one time, could we reasonably expect it to work in the future (would people not learn from the outcome and tailor their strategies accordingly?). If you believe that people are fundamentally irrational in this sense, then you will make a fine behavioral economist (and a poor philosopher king).

So what is the solution to Solomon's dilemma?

One approach might be to adopt the Coase theorem, which states that if transaction costs are zero, then an arbitrary assignment of property rights will lead to the efficient solution. That is, Solomon could just have assigned the baby at random to one or the other woman. If it fell into the hands of the false mother, the true mother (who presumably values the baby more) could then purchase the baby (from the one who values it less). In other words, if there are gains to trade (as would obviously exist in this case), then these gains will be realized--if transaction costs are zero.

The problem with this approach is that transaction costs are obviously not zero (these costs could arise, for example, if the true value of the baby by both women is private information). Moreover, this "solution" violates what most people would consider to be a principle of "fairness" (why should the true mother pay for her own baby?). The Coase theorem is a fascinating theorem, but it should not be applied as a solution to the problem at hand; the theorem simply states what one could expect to happen IF transaction costs are zero. In fact, the Coase theorem should be interpreted as explaining precisely why various institutions emerge to handle the problem of resource allocation in a world where transaction costs are not zero.

One such solution was offered by Solomon. But I have already highlighted the problem with his proposed institution (or mechanism). Another possible solution was offered by William Vickery: a sealed-bid second-price auction (or a Vickery auction). Assume, as seems reasonable in this case, that only the two mothers know the true value they attach to the baby. A Vickery auction would have both mothers submitting sealed bids for the baby. The woman with the highest bid would then win the auction, but pay the second-highest bid.

This solution is clever because the amount that either woman expects to pay is independent of their actual bid. Accordingly, neither one of them have an incentive to misrepresent how much they really value the baby. If the true mother values the baby more, she will win the auction (it would not be rational for the false mother to bid more than what the baby is worth to her).

Clever indeed. But there is still a problem associated with this solution. In particular, it requires that the true mother actually pay for her baby. Leaving issues of "fairness" aside, a more relevant problem may be that this mother does not have the resources to make the requisite payment. (It is absolutely critical that the payment be forthcoming; if Solomon could not credibly commit to collecting the payment, then rational players will understand this limitation and alter their strategies accordingly).

One solution might be to let the women offer themselves as indentured servants. This sounds feasible and has the desirable property that the true mother gets her baby (she would presumably be happy to offer herself as Solomon's servant, if it means getting her baby). While this solution has its drawbacks, it seems to dominate Solomon's solution--something that risks having the baby split in two.

But is it possible to design a mechanism that "does the right thing" without any cost to the true mother? Several solutions have been proposed in the literature; but each with its own peculiar drawbacks. But I recently came across one proposed solution that seems quite clever; see Bid and Guess: A Nested Solution to King Solomon's Dilemma, by Cheng-Zhong Qin of UC Santa Barbara.

The idea as presented in Qin's paper seems a little more complicated than it needs to be (but I could be wrong). The basic idea, as I see it, is to have the women play a "participation game" just before playing a standard Vickery auction. We could set up the mechanism as follows.

First, Solomon informs the women of the Vickery auction that will be used to allocate the baby. Second, he informs each woman that the price of participating in the Vickery auction will be a half-life of servitude in some miserable occupation. The women are then asked to submit envelopes with ballots that are marked "yes" or "no" (yes, I am willing to participate; no I am not). If both women submit "yes," then the Vickery auction is played. If only one woman submits "yes," then the baby is allocated to her for free (the auction is not played). If neither woman submits "yes," then the baby is disposed of in some manner (perhaps in the King's service).

Now, put yourself in the place of first, the true mother and second, the false mother. How would you play the game? Would you say "yes" or "no?"

Theory suggests that the true mother will say "yes" to the participation game (she knows that she will get the baby if the auction is played; she will pay one half-life of servitude for participation, and the other half-life in payment for the baby). Likewise, the false mother will say "no." Why submit to a half-life of servitude when she knows that she will inevitably lose the subsequent auction? The false mother will rationally bow out of the bidding; she will choose not to participate. And the baby is allocated for free to the true mother.

Of course, this assumes that the people playing this game are "rational" in the sense that they understand the rules of the game and in the sense that they can anticipate how others are likely to play it. One of the great strengths of assuming rationality in this form is that the assumption can be applied as a general condition that prevails in any resource allocation problem. Its weakness is that people may not always possess this assumed degree of rationality.

But the alternative--the "behavioral approach"--suffers from an even greater problem. In particular, the policymaker must be aware of precisely how people are irrational in each and every given circumstance (a great loss in generality). There are an infinite number of ways in which people might be irrational; and the behavioral theorist is forced to choose among an infinite number of "behavioral rules" that he or she believes captures this irrationality in a plausible manner. The only hope that a behavioral theorist has for developing a general theory is in discovering that people are irrational in some systematic manner. But if the theorist can identify this systematic pattern of irrationality, it seems hard to know why people cannot discover it for themselves too. But then, it seems clearly in the interest of aspiring philosopher kings prefer to think of themselves as being systematically more rational than the subjects they study.

South Park on the Financial Crisis

Am winding down a two-week visit at the department of economics at Nanterre (Paris X). Paris is lovely, even at this time of year. And naturally, I have fallen in love...with the bakery next to my flat (a sure sign of old age, when one prefers to oggle a fresh baguette in a shop window, rather than the pretty Parisiennes walking down the street).

During my idle time (digestive phase), I surf the net for amusing/interesting pieces. Most of my searches have turned up idiotic musings by the likes of Buiter, DeLong, and comrade Anatole. But here now, I have finally found the jewel among the rot: an episode from South Park that draws on Monty Python's "The Life of Brian."

This is absolutely brilliant; a short clip is available here.

I wonder whether all the finger-pointers might recognize themselves? (I doubt it).

Goodbye, Homo Economicus

Here we have Anatole Kaletsky, giving us his version of the Buiter rant: Goodbye, Homo Economicus.

Who is Anatole Kaletsky? Evidently, he is an "economist." Well, more like a journalist-economist-consultant-forecaster. That is, he is a snake-oil salesman; which is to say, he is richer than you or I.

In this fine piece, Kaletsky argues that economists must take the blame for the current financial crisis. Well, not all economists, of course. Not economists like Kaletsky, for example. Not the "talking head" economists, or the economists who like to forecast things. The blame lies with academic economists...like me. Well, I am sorry. I am truly sorry for causing the crisis.

The fault lies with academics who plant crazy ideas into the minds of people (adults who cannot possibly be held responsible for what they learn). Crazy ideas like efficient markets, the glory of capitalism, blah, blah, blah. One can certainly see how these crazy ideas have manifested themselves as unbridled capitalism run amok (it is inconvenient here to observe that the financial sector is by far the most heavily regulated sector in any "well-developed" economy).

To flash his eruditeness, Kaletsky offers us the following quote from Keynes:

Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.

I like this quote and agree with it. Kaletsky evidently believes that the economist is to blame for this; rather than the madmen who adopt their ideas. Evidently, Kaletsky must have skipped some classes at Cambridge. I see that Keynes (1923) also said:

The theory of economics does not furnish a body of settled conclusions immediately applicable to policy. It is a method rather than a doctrine, an apparatus of the mind, a technique of thinking which helps its possessor to draw correct conclusions.

This is something that Kaletsky evidently does not understand. He certainly shows none of the humility that academic economists demonstrate when it comes to understanding the world around them. For example, take a look at Kaletsky's bold predictions for the economy (made January 2008), Goodbye to all that: the worst is over for the global credit crunch.

His predictions are as follows:

[1] The global credit crisis is now almost over;
[2] There will be no U.S. recession;
[3] Stock markets around the world will rise in 2008;
[4] There will be a "decoupling" between the U.S. and Asia;
[5] The sterling will fall against every other major currency

Incredibly, every single one of his predictions failed to materialize. This takes an incredible amount of skill (generally, bullshit forecasts can expect to be correct 50% of the time). But I suppose that the fault here again lies with academic economists. Shame on all of you!

Larry Summers on Fear and Greed

I used to think that Larry Summers was a reasonable sort of fellow. By here is some evidence proving that spending too much time in administration and politics can rot even the best mind; see White House: Greed Will Help. Here are some quotes:

"In the past few years, we’ve seen too much greed and too little fear; too much spending and not enough saving; too much borrowing and not enough worrying," Summers said Friday in a speech to the Brookings Institution. "Today, however, our problem is exactly the opposite."

Borrowing, you see, is evidently linked to greed; especially if one borrows too much. I am reminded of university students who mindlessly accumulate too much student debt. The greedy bastards. Or of poor people mindlessly borrowing to finance a home purchase. The greedy SOBs. There is too much borrowing; too much spending; there is too much greed.

Saving, on the other hand, is evidently linked to fear. Fear is a virture (as in the fear of God). As when all those virtuous savers bid up the NASDAQ to 5000. Whoops; this doesn't sound right. Perhaps he means saving in virtuous assets, like government treasuries (backed by virtuous/coercive taxation; rather than the prospect of future cash flow from a successful enterprise). Yes, fear is a virture...unless there is too much fear. Then fear is bad.

To summarize then: greed is vice; fear is a virtue. Unless there is too much fear, which is not a virtue. Not enough greed is a virtue; but not a good virtue...which is to say it is a vice. I am getting confused. Let me consult the article again.

"While greed is no virtue, entrepreneurship and the search for opportunity is what we need today."

OK, this clears things up. Make no mistake: greed is no virtue. But we do need more of it at a time like this. So to sum up, greed (borrowing) is bad and fear (saving) is bad (unless there is not enough of either). In the world economy (a closed system), we know that borrowing = saving. And this proves that greed is always balanced by fear. Wait a second, I am confused again. Perhaps what we need is a "new generation" IS-PC-TR like model to help policymakers confront the difficult economic choices they face in balancing fear and greed.

Assume that the policymaker has a quadratic loss function in deviations of actual fear and greed around some socially optimal level of fear and greed (we will let Woodford provide the microfoundations for this social welfare function). Accordingly, let us write this loss function as,

L(t) = 0.5(f(t) - f)^(1/2) + 0.5(g(t) - g)^(1/2)

Here, (f,g) are the socially optimal levels of fear and greed. f(t) and g(t) are the prevailing levels of fear and greed at date t. The policymaker wishes to minimize the fluctuations in fear and greed around their socially optimal levels.

We need more restrictions. Let's see. It seems natural to suppose that fear is influenced in some manner by endogenous variables and an exogenous shock; let's say

f(t) = a*f(t-1) - b*y(t) + e(t)

where y(t) is the output gap; and e(t) is the shock (like a "fear" markup shock in New Keynesian models).

Greed, on the other hand, is influenced by the interest rate and exogenous factors; e.g.,

g(t) = c*g(t-1) - d*r(t) + u(t)

where r(t) is the interest rate, set by monetary policy. Lowering r(t), the way Greenspan did, results in an increase in greed. Seems right.

Now, the policymaker wishes to choose an interest rate rule that miminizes the loss function, given the stochastic processes (estimated as the residuals from a mindless OLS or VAR) governing the fear and greed shocks.

Yes, I can see how the New Keynesian model, so widely used by central banks to justify the policies they follow, will no doubt be replaced by my formalization of Summer's hypothesis. The implications for policy design are likely to prove equally enlightening. Anyone care to coauthor this paper with me? Fame (or notoriety) is virtually guaranteed!

CDO Squared, Anyone?

Along with Martin Hellwig, I think that the other bright light in the field of finance is Gary Gorton of Yale. He has published several very interesting papers on historical banking panic episodes; see here. He gives a detailed account of the subprime mortgage market and the financial innovations associated with it in his paper entitled "The Panic of 2007."

In this paper, he describes the nuances of subprime mortgages; in particular, how their particular design made them very sensitive to the underlying asset price (unlike conventional mortgages). Evidently, this was by design (there was no other way for creditors to make money servicing this particular demographic).

He goes on to describe how these subprime mortgages were packaged into mortgage backed securities (MBS). This is a common form of securitization (although, the design of these also differed in a subtle, but important manner, from standard securitizations). As with other securitizations, mortgages were pooled and then tranches were formed; e.g., a senior tranche, a mezzanine tranche, and an equity tranche.

This type of securitization has an economic rationale. Higher rated tranches can be sold to insurance companies and pension funds (whose liabilities are longer term in nature). In principle, the originator of the MBS should could then hold on to the junior (equity) tranche. This gives the originator the incentive to construct a sound MBS; as the originator is the first in line to potential losses.

What I do not understand is what followed. These MBS were then used as backing for new securities, called Collateralized Debt Obligations (CDOs). For example, the mezzanine tranche of the MBS (rated BBB) would then be divided into senior, mezzanine, and junior tranches. The mezzanine tranche of this CDO would then be divided again into senior, mezzanine, and junior tranches (a CDO squared). The senior tranches of the CDO squareds would be assigned AAA ratings!

I do not understand the economic rationale for this further subdivision of the original MBS. I presume that there must be one (perhaps to get around some government regulations?). Is there an expert in finance out there that can help me out? I have had little luck in finding anything that explains the motivation for why CDOs exist.