Taken Out Behind the Woodshed

Been out of commission for a while. (Had Lasik surgery on Monday -- I can actually see now -- which will no doubt please those who accuse me of blindness). And I have just now read the replies to my previous two posts. Not very pretty. I'll have a few things to say about this. Before I begin though, I would like to take a moment to thank all my supporters out there: thanks...you've both been great!

When I originally contemplated the idea of Macromania, I thought it might be a cheap and interesting way to learn a few things. By and large, it has turned out to be a successful experiment (for me personally, at least).

But not everything in the experiment has turned out well. My more thoughtful postings were met with thoughtful replies, followed by fruitful discussion. My more childish personal attacks on people I did not even know were met by counterattacks of a similar nature by people who do not even know me. I am now reminded of a useful Bible lesson: As you sow so shall you reap.

There is nothing wrong, I think, with the harsh criticism of an idea. Having a stupid idea does not make one stupid. But it is another thing altogether when one criticizes a person. And here I confess to having gone too far. There are probably times and places where personal attacks might be justified, but I don't want Macromania to be a venue for that sort of activity. Nothing good comes of it.

So I would like to clear the air. Both Paul Krugman and Brad DeLong deserve far more respect that what I afforded them. (Let me also toss Ron Paul in there, who has at times found himself in my crosshairs). My ego is not so large as to expect that they would welcome an apology from me. But I would like to apologize nevertheless, for the record, if for nothing else.

And while I'm clearing the air, I would like to reply to Mark Thoma's post here. Mark takes some justified jabs at me. But he also misrepresents me along a few dimensions. Again, for the record:

[1] I am neither for nor against fiscal stimulus in the form of government purchases to combat a peacetime economic crisis (I have repeatedly said that I am an agnostic whose beliefs on the matter vary over time as I am exposed to more evidence). I have, in fact, made arguments elsewhere in favor of fiscal policy as a redistributive mechanism (but sadly, in my view, redistribution is never mentioned in this debate; it's all about the effect of G on Y).

[2] What I am against is the practice (perhaps it is unintended or simply a product of my imagination) of seducing the public into thinking that our "science is settled" on any given question. Greg Mankiw's more cautious approach as exhibited here teaches us how to persuade without being dogmatic.

[3] I have never, as far as I can remember, disputed the logic of fiscal stimulus in a NK model with zero nominal interest rates. But the NK model is not the only game in town. There are competing frameworks (for example, the so-called New Monetarist framework) that are no less plausible and may deliver very different answers to the same policy question. We need to keep an open mind and avoid making bold assertions on the basis of a single model.

OK, now let's go do some economics.

On Krugman (Again)

I seem to have hit a nerve with Mark Thoma in my previous post (see his comments). Apparently, he took issue with my suggestion that Paul Krugman's theoretical contributions to macroeconomic theory are close to nil. Mark goes so far to suggest that if we had all just read Krugman's work on Japan's liquidity trap, that we could have all been spared reinventing the wheel. Really?

In fact Mark, I had read his thoughts on the liquidity trap (and I thought they were pretty good, which shouldn't be confused with I thought they were original). Indeed, during my visit at the BOJ in 2002, I offered some of my own speculations on the matter (see here). Here is a quote from that piece:

I conclude with some thoughts on the potential role for fiscal policy. Some economists, notably Krugman (1999) and Eggertsson (2002), have advocated the use of fiscal policy as a means of “stimulating” the economy when it finds itself in a “liquidity trap” scenario. The model that I present below is consistent with this idea. In particular, by increasing the rate of expansion of nominal government debt, the fiscal authority can drive down the expected real rate of return on government securities (by increasing the expected inflation rate), thereby inducing asset substitution from government securities into capital investment. However, whether such a policy is likely to have a quantitatively important effect and whether such a policy would even be desirable in terms of economic welfare are still questions open to debate.

Open to debate, that is, as far as I was concerned. Not to (the post Nobel prize) Krugman, or any of his devout followers.

So Krugman "discovered" the liquidity trap in 1999? He discovered the proposition that a swap of two zero-interest bearing securities (money and government debt) is not likely to have a significant impact on the wealth portfolios of individuals? Well done (but wasn't this known already?).

What I find insufferable about the man is not that he is necessarily incorrect; it is the manner in which he proclaims things to be absolutely true (something that I don't detect in his earlier writings). Even worse is the faint, but unmistakable hint that the reader is a moron for not capitulating at his alter of higher wisdom.

What do I mean by this last statement? Well, take a look here, for example. That's for all of you stupid PhDs who cannot understand how a sticky price model works. You see, just assume that free markets do not work well (prices are sticky). Then you assume that the government works really well. Homework: deduce the correct policy implications.

Another irritating aspect of the man is the way he likes to label the assumption of sticky prices as a Keynesian construct. What is irritating is not so much that he does this (as do almost all NK types); it is that he frequently berates others (notably Barro) for not reading the General Theory properly (or at all). Well, here's a quote from the General Theory for all you NK fans:

In this summary, we shall assume that the money-wage and other factor costs are constant per unit of labour employed. But this simplification, which we shall dispense later, is introduced solely to facilitate the exposition. The essential character of the argument is precisely the same whether or not money wages are liable to change. (Chapter 3, Part II)

In other words, the assumption of sticky prices/wages has absolutely nothing to do with Keynes' theory. In fact, he would argue later on that to the extent that prices/wages are sticky, that this would be good thing (it would prevent a further fall in incomes that would serve to exacerbate any demand deficiency).

Mark pointed me to this Krugman piece, which I had not seen before (thanks, Mark). Evidently, one thing that has really been "bothering" Paul is the absence of "fully worked out models." In light of his history of coming down hard on one side of this debate, I can hardly believe that he is being sincere. But maybe he is, and maybe I've been wrong about the guy.

I'll have more to say once I finish reading it carefully.

The Krugman and DeLong Circus

Love them or hate them, they certainly make for fun reading. Personally, I find both of these characters fascinating because I cannot tell whether they are being serious, or whether they're simply play-acting.

I try to resist an overwhelming temptation to view Krugman as clever but evil, and DeLong as decent, but somewhat dim. Who knows...perhaps we are all these things some of the time?

DeLong certainly appears to have a lot of "energy." Not a focussed energy, but energy nevertheless. Where he finds the time to manage his blog Grasping Reality with Both Hands, I have no idea. In any case, you have to love the subtitle:

The Semi-Journal of Economist J. Bradford DeLong: Fair, Balanced, Reality-Based, and Even-Handed.


You've got to be kidding me, right? Believe me, he may be many things, but he certainly ain't no economist!

O.K., that was supposed to be a joke. But really, does the guy really believe that "fair and balanced" crapola? Can you believe that he really believes this?

Anyway, it should come as no surprise that DeLong loves Krugman almost as much as he loves himself. Here is Brad's review of Krugman's The Accidental Theorist. I quote:

Of all the books of short essays that Paul Krugman has written, I think that this is the very best: you can learn an awful lot of economics from this book, for Krugman's usual clarity and force of argument is raised to a higher power in this book.

Hmmm...well, I'm willing to grant that one may indeed learn a lot of awful economics from Krugman. I'm just kidding (again). I've read many (older) Krugman articles and found them good enough to assign to my classes. The Krugman-Helpman text on trade theory was leading edge. He won his Nobel prize for his work on trade theory, after all.

Precisely how this makes him an authority on macroeconomic theory, I'm not exactly sure. Paul just wants to talk about macro because it's more fun, I guess. I am reminded of when William Vickrey won a Nobel for his work on auction theory. Rather than talk about issues in the area of his expertise, he too spent all his time pontificating on all things macro. Go figure.

Anyway, DeLong tells us that we can learn a lot of economics from Krugman. You will be forgiven for wondering whether DeLong can even tell whether he is learning economics or not. DeLong is, as far as I can tell, an historian. Sometimes he is a good one. Sometimes, he is not so good. But whatever one's view of his abilities as an historian, I have come across no evidence that would lead me to believe that he has any deep understanding of modern macroeconomic theory. I'm not sure how he passed his macro core exam.

This little love affair runs both ways. Here is Krugman "chiding" DeLong (i.e., smacking down Cochrane): Brad DeLong's Foolishness.

It looks as if DeLong was trying to figure out Cochrane's model (have to give him credit for that, at least). But hold on there Brad, Paul says that you shouldn't be doing that: Cochrane has no model to speak of!

Ho boy, this is rich: Paul Krugman complaining that John Cochrane has no model! Since when has Krugman ever let a (serious) model temper or change a prior point of view?

Krugman complains that Cochrane does not understand the "logic" of Keynesian models. Krugman, evidently does understand this logic. This is the same Krugman who called Robert Barro a "bonehead" for not understanding Keynesian logic (see here). That would be the same Robert Barro who, along with Gene Grossman, struggled mightily to formalize the Keynesian logic (Barro-Grossman model, AER 1971). I believe that Barro also serves up the Keynesian model later on in his text (explaining that the issues that arise there are more advanced, hence the reason for why they are saved for later).

Where is the evidence that Paul Krugman has ever thought deeply about the theoretical foundations of Keynesian theory? (Maybe there is some and I have just missed it). As far as I can tell, his "deep" understanding goes no further than an elementary Keynesian cross (OK, OK, maybe he knows a bit more than this).

So, what do I take away from all this? Well, I conclude that it should be clear enough that this dynamic duo are primarily interested in pushing their own pet political agendas; they have no interest in pushing the frontier of economic theory (they apparently know how the world works, so there is evidently nothing left to learn). Nothing wrong with this, of course. They are at their best at calling out the absurdities of some claims made by the "lunatic right." Nothing wrong with this either.

Nothing wrong, that is, except when they label these activities as "fair and balanced" or as "rooted in rigorous theory." That's just plain dishonest.

Greg Mankiw on Fiscal Policy

Just over one year ago, when "fiscal stimulus" was all the rage, I asked what I thought was a simple question: How do the proponents of fiscal stimulus know that it works? More precisely: what evidence can we bring to bear on the question of whether a large increase in government spending during a peacetime economic crisis stimulates GDP in a welfare-improving manner? (I allowed for the possibility that such a spending program may have desired redistributional aspects, but redistribution is patently not what people talk about when they speak of the benefits of fiscal stimulus--it is something that is supposed to make us all better off).

In case you're interested, you can refer to:

Does Fiscal Spending "Work?"
Believing in Fiscal Stimulus.
Believing in Fiscal Stimulus 2.

I appeared to have hit a nerve with some people on this topic. One chap named Bruce Wilder was particularly amusing (that is, if you find appalling ignorance and santimonious drivel amusing). This "debate" had the side benefit of leading me to think about a theory of religion. In any case, the record of this exchange can be found here:

Bruce Wilder on Andolfatto.
Religiousity in Macroeconomics and the Sad Case of Father Wilder.

As far as I was (am still) concerned, it all boiled down to personal beliefs (religion). There is simply not enough data (as far as I am aware of) that could lead any honest (agnostic) scientist to come down strongly on one side of the debate or the other. It led me to question to academic integrity of strong proponents of fiscal stimulus like Paul Krugman and Brad DeLong. (I do not feel quite the same way for strong opponents, as they are usually more honest about their beliefs: they simply do not want the government to interfere in the lives of its citizens, period. However, this may simply reflect a defect or bias on my part).

And then along comes Greg Mankiw, a self-described Keynesian. He recently published this in the Federal Reserve Bank of St. Louis Review: Questions About Fiscal Policy.

Mankiw is a gifted writer. I encourage you to read it. He begins the paper with a great analogy. But what I really loved was this line:

I am actually a believer in Keynesian theory; much of my research is in that field. But even as a believer in many aspects of Keynesian theory, I appreciate that you cannot approach this subject matter without showing some humility about what we, as economists, can truly be confident about.

My only quibble is why he only included economists in that worthy sentiment.

Other than that, all I have to say is:

Amen

John Cochrane on a Euro-Greek Tragedy

An excellent piece today by John Cochrane in the WSJ here. Here it is (in case you do not subscribe).

====================

Last week the Greek bailout ballooned into a gargantuan 750 billion euro (nearly $1 trillion) debt stabilization fund, including a $39 billion line of credit from the International Monetary Fund. This coincided with the European Central Bank (ECB) announcement that it would immediately begin purchasing junk-rated Greek debt.

It won't work. The problem isn't liquidity, psychology or speculators. Germany and France simply cannot borrow or tax enough to cover Europe's debts and looming deficits. So, barring a fiscal and growth miracle, we will either see sovereign defaults (larger and more chaotic for having been postponed) or the ECB will have to print euros to buy worthless debt, leading to widespread inflation. Since inflation lowers the value of promises to state workers and pensioners, and also is easy to blame on others, it will be an especially tempting escape.

Notice who is missing: Greek bondholders are not being asked to miss a single interest payment, reschedule a cent of debt, suffer any write-down, take a forced rollover or conversion of short to long-term debt, or any of the other messy ways insolvent sovereigns deal with empty coffers. Those who bought credit default swaps lose once again.

But why? The reasoning behind the Greek bailout is founded on several myths that need exploding:

• Saving the euro. We're told a Greek default would imperil the euro.

The opposite is true. Allowing Greece to default, or to renegotiate with bondholders, would be the best way to save the euro. A currency union is strongest without fiscal union. Then
countries are no different from companies. If they borrow and cannot pay back, investors lose money. The currency is unaffected.

The euro could become a monetary union with full fiscal union. I hate to think what EU budgets and taxes would look like if they were all run from Brussels, but at least that system might impose some discipline on national governments' incentive to borrow, spend, and demand bailouts.

But the euro will be a disaster as a monetary union with loose fiscal controls and constant speculation about will-they-or won't-they (or can-they-or-can't-they) trillion-euro bailouts and ECB financing. The Europeans have found the worst possible combination.

How did this happen? The euro's founders wrote rules against sovereign bailouts. They almost created a perfect currency: an international standard of value and medium of exchange, with a central bank mandated only to maintain a stable price level. The euro was not to be devalued to wipe out government debts or to gain temporary (and often illusory) trade or employment
advantages. In the next U.S. inflation crisis, the euro might have succeeded the dollar as the international reserve currency.

But the euro's founders also set debt and deficit limits. The problem is not that these limits were too loose. The problem is having them at all. The mere existence of the limits says, in effect, that politicians will have a hard time resisting bailout pressure. So the markets lent at low rates and gave high bond ratings. The EU rediscovered that it's much harder to grow a spine in the middle of a crisis.

The euro founders should have said instead, "Go ahead, use our currency if you like. Rack up any debts you want. We don't care, because we are not going to bail you out—we've set it up so we can't bail you out. Bond buyers beware."

The euro founders never decided whether they were creating the perfect currency without fiscal union, or if they were creating a fiscal union on the way to political union. They never decided if the euro was going to be the national currency for a future United States of Europe or a gold standard for the modern age. Now they have neither.

• Contagion.

We're told that a Greek default will lead to "contagion." The only thing an investor learns about Portuguese, Spanish, and Italian finances from a Greek default is whether the EU will or won't bail them out too. Any "contagion" here is entirely self-inflicted. If everyone knew there wouldn't be bailouts there would be no contagion.

• Systemic risk.

We're told that a Greek default will threaten the financial system. But how? Greece has no millions of complex swap contracts, no obscure derivatives, no intertwined counterparties. Greece is not a brokerage or a market-maker. There isn't even any collateral to dispute or assets to seize. This isn't new finance, it's plain-vanilla sovereign debt, a game that has
been going on since the Medici started lending money to Popes in the 1400s. People who lent money will lose some of it. Period.

• Saving the banks.

We're told that Greece must be bailed out, or large banks will fail. Savor the outrageous irony of this claim. Apparently, two years after the great mortgage meltdown, Europe's army of bank regulators missed the fact that large, "systemically important" banks had made firm-threatening bets on Greek debt. So much for the idea that more regulation will keep complex banks out of trouble.

If the claim is true (which I doubt), the right answer is to save the specific "systemically important" banks (or, better, their "systemically important" activities), not to bail out every Greek bondholder and the Greek government and to paper over the vast bank and regulatory failure that set up the problem.

Greece got in to trouble when it tried to sell new debt to repay its maturing short-term debt, just as Bear Stearns and Lehman Brothers did. If Greece had sold long-term debt, there would be no sudden crisis. In all the talk of restructuring euro finances, nobody is talking about forcing governments to borrow long-term, nor of managing the crisis by forcing short-term debtholders to accept new long-term debt rather than cash.

Letting someone lose money on sovereign debt is the acid test for the euro. If not now, when? It won't happen in good times, nor to a smaller country. The sooner the EU commits, and other countries and their lenders come to terms with the fact that they will not be bailed out, the better.

The current course—ever-larger and less-credible bailout promises, angry German voters who may vitiate those promises, vague additional fiscal supervision (i.e. more of what just failed miserably)—is not the answer.

The only way to solve the underlying euro-zone fiscal mess (and our own) is to slash government spending and to focus on growth. Countries only pay off debts by growing out of them. And no, growth does not come from spending, especially on generous pensions and padded government payrolls. Greece's spending over 50% of GDP did not result in robust growth and full coffers. At least the looming worldwide sovereign debt crisis is heaving "fiscal stimulus" on the ash heap of bad ideas.

On Ron Paul and the Fed

What a way to start the day. Another interview on CNBC this morning with Ron Paul: Fed to Blame for Everything

Let me come clean: I basically share the man's distrust of heavy concentrations of power. And I think that secular stability in the general level of nominal prices is probably a good idea too. Thus, it appears that we share a number of beliefs. So why does the guy make my eyes roll whenever I hear him speak?

His problem, in a nutshell, is this: He ascribes too much power to the Fed. The power in the U.S. resides in Congress. It is Congress that spends, taxes, and issues treasury debt. Traditionally, the Fed simply determined the composition of government debt between its interest-bearing (debt) and non-interest-bearing (money) components. What sort of power is this? (Especially in relation to the power of Congress).

Ah yes, but the Fed has greater power than this. It can "lend to its friends" and "let its enemies fail." I presume he is talking about the Fed's emergency lending facilities, all of which have now wound down, with a healthy profit for the U.S. taxpayer.

But I am missing the point: The Fed has the ability to create money "out of thin air!" Whenever I hear this expression, I chuckle. We all have the power to create debt out of "thin air." When Microsoft creates shares to finance an acquisition, it creates the shares "out of thin air." If you bum a beer from a friend and promise to repay him next week, you create a debt obligation "out of thin air." Ooooo..."out of thin air!"

Evidently, Paul has been forecasting the current problems of the world since 1971 (the breakdown of the Bretton Woods system). Yep, there were certainly no problems prior to this. No inflation to speak of. Well, maybe a bit during the Korean war. And maybe a bit more during the Vietnam war. Oh, and let's not forget Lyndon Johnson's war on poverty. Fiscal strain, fiscal strain, fiscal strain...all the fault of the Fed, no doubt. This fiscal strain apparently had nothing to do with the breakdown of Bretton Woods...no, let's just blame the Fed for going off the gold standard. As if Arthur Burns had more power than Richard Nixon.

To be fair to Ron Paul, his position appears to be this. It is not ultimately the fault of the Fed. It is the fault of those in Congress who would like to use the Fed as their personal piggy bank to finance their pet "great society" spending initiatives. What Paul would like to see is an institution that prohibits Congress from making sneaky appropriations through the inflation tax.

If this is his view, then I have some sympathy for it. But I think that his energy here could be better spent elsewhere: there are bigger fish to fry in the realm of fiscal policy reforms.

Beware of Greeks Bearing Debt

I cannot believe that Greek Prime Minister George Papandreou is a stupid man. So I attribute the following to how low a politician can find it profitable to stoop:

Greek Leader Considers Actions Against U.S. Banks

Here are some choice bits.

Both the Greek government and its citizens have blamed international banks for fanning the flames of the debt crisis with comments about Greece's likely default, actions that are causing the country's borrowing costs to soar.

Right. Those big bad international banks (you know...the ones that lent you all that money)...they are now trying to scare everyone into thinking you won't repay! Greek citizens themselves, running amok through the streets of Athens, have done nothing themselves to fan these flames. Nope, nosiree.

Papandreou also said a parliamentary investigation will examine the rapid swelling of Greece's debt and international banking practices to examine whether the financial sector engaged in "fraud and lack of transparency."

I think I may have been wrong: perhaps he is stupid. Shameless, at the very least. Stupid for believing that anyone won't blush at the hyprocisy underlying this statement.

The Greek leader also urged more regulation of the markets which, in his view, are now betting against the European governments that have poured billions into them since the global financial crisis began in 2008.

Yes, yes...let's have a regulation in place that prohibits anyone from taking bets against Greece. What a wonderful idea. Practical too.

"We are ready to make the changes ... we have made our mistakes. We are living up to this responsibility. But at the same time, give us a chance," Papandreou said.

I think that people would dearly love to, Mr. Papandreaou. But you are making it very difficult!

Note to the PM: If you want lower borrowing costs, then why not pawn one or two islands? No one would take you seriously, of course. Which is precisely the point, I'm afraid.