Falling Real Interest Rates, Winner-Take-All Markets, and Lance Armstrong

Published January 16, 2013 Irving Fisher , Jack Hirshleifer , winner-take-all markets 5 Comments
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In my previous post, I suggested that real interest rates are largely determined by expectations, entrepreneurial expectations of profit and household expectations of future income. Increased entrepreneurial optimism implies that entrepreneurs are revising upwards the anticipated net cash flows from the current stock of capital assets, in other words an increasing demand for capital assets. Because the stock of capital assets doesn’t change much in the short run, an increased demand for those assets tends, in the short run, to raise real interest rates as people switch from fixed income assets (bonds) into the real assets associated with increased expected net cash flows. Increased optimism by households about their future income prospects implies that their demand for long-lived assets, real or financial, tends to decline as household devote an increased share of current income to present consumption and less to saving for future consumption, because an increase in future income reduces the amount of current savings needed to achieve a given level of future consumption. The more optimistic I am about my future income, the less I will save in the present. If I win the lottery, I will start spending even before I collect my winnings. The reduced household demand for long-lived assets with which to provide for future consumption reduces the value of such assets, implying, for given expectations of their future yields, an increased real interest rate.

This is the appropriate neoclassical (Fisherian) framework within which to think about the determination of real interest rates. The Fisherian theory may not be right, but I don’t think that we have another theory of comparable analytical power and elegance. Other theories are just ad hoc, and lack the aesthetic appeal of the Fisherian theory. Alas, the world is a messy place, and we have no guarantee that the elegant theory will always win out. Truth and beauty need not the same. (Sigh!)

Commenting on my previous post, Joshua Wojnilower characterized my explanation as “a combination of a Keynesian-demand side story in the first paragraph and an Austrian/Lachmann subjective expectations view in the second section.” I agree that Keynes emphasized the importance of changes in the state of entrepreneurial expectations in causing shifts in the marginal efficiency of capital, and that Austrian theory is notable for its single-minded emphasis on the subjectivity of expectations. But these ideas are encompassed by the Fisherian neoclassical paradigm, entrepreneurial expectations about profits determining the relevant slope of the production possibility curve embodying opportunities for the current and future production of consumption goods on the one hand, and household expectations about future income determining the slope of household indifference curves reflecting their willingness to exchange current for future consumption. So it’s all in Fisher.

Thus, as I observed, falling real interest rates could be explained, under the Fisherian theory, by deteriorating entrepreneurial expectations, or by worsening household expectations about future income (employment). In my previous post, I suggested that, at least since the 2007-09 downturn, entrepreneurial profit expectations have been declining along with the income (employment) expectations of households. However, I am reluctant to suggest that this trend of expectational pessimism started before the 2007-09 downturn. One commenter, Diego Espinosa, offered some good reasons to think that since 2009 entrepreneurial expectations have been improving, so that falling real interest rates must be attributed to monetary policy. Although I find it implausible that entrepreneurial expectations have recovered (at least fully) since the 2007-09 downturn, I take Diego’s points seriously, and I am going to try to think through his arguments carefully, and perhaps respond further in a future post.

I also suggested in my previous post that there might be other reasons why real interest rates have been falling, which brings me to the point of this post. By way of disclaimer, I would say that what follows is purely speculative, and I raise it only because the idea seems interesting and worth thinking about, not because I am convinced that it is empirically significant in causing real interest rates to decline over the past two or three decades.

Almost ten months ago, I discussed the basic idea in a post in which I speculated about why there is no evidence of a strong correlation between reductions in marginal income tax rates and economic growth, notwithstanding the seemingly powerful theoretical argument for such a correlation. Relying on Jack Hirshleifer’s important distinction between the social and private value of information, I argued that insofar as reduced marginal tax rates contributed to an expansion of the financial sector of the economy, reduced marginal tax rates may have retarded, rather than spurred, growth.  The problem with the financial sector is that the resources employed in that sector, especially resources devoted to trading, are socially wasted, the profits accruing to trading reflecting not net additions to output, but losses incurred by other traders. In their quest for such gains, trading establishments incur huge expenses with a view to obtaining information advantages by which profits can be extracted as a result of trading with the informationally disadvantaged.

But financial trading is not the only socially wasteful activity that attracted vast amounts of resources from other (socially productive) activities, i.e., making and delivering real goods and services valued by consumers. There’s a whole set of markets that fall under the heading of winner-take-all markets. There are some who attribute increasing income inequality to the recent proliferation of winner-take-all markets. What distinguishes these markets is that, as the name implies, rewards in these markets are very much skewed to the most successful participants. Participants compete for a reward, and rewards are distributed very unevenly, small differences in performance implying very large differences in reward. Because the payoff at the margin to an incremental improvement in performance is so large, the incentives to devote resources to improve performance are inefficiently exaggerated. Because of the gap between the large private return and the near-zero social return from improved performance, far too much effort and resources is wasted on achieving minor gains in performance. Lance Armstrong is but one of the unpleasant outcomes of a winner-take-all market.

It is also worth noting that competition in winner-take-all markets is far from benign. Sports leagues, which are classic examples of winner-take-all markets, operate on the premise that competition must be controlled, not just to prevent match-ups from being too lopsided, but to keep unrestricted competition from driving up costs to uneconomic levels. At one time, major league baseball had a reserve clause. The reserve clause exists no longer, but salary caps and other methods of controlling competition were needed to replace it. The main, albeit covert, function of the NCAA is to suppress competition for college athletes that would render college football and college basketball unprofitable if it were uncontrolled, with player salaries determined by supply and demand.

So if the share of economic activity taking place in winner-take-all markets has increased, the waste of resources associated with such markets has likely been increasing as well. Because of the distortion in the pricing of resources employed in winner-take-all markets, those resources typically receiving more than their net social product, employers in non-winner-take-all markets must pay an inefficient premium to employ those overpaid resources. These considerations suggest that the return on investment in non-winner-take-all markets may also be depressed because of such pricing distortions. But I am not sure that this static distortion has a straightforward implication about the trend of real interest rates over time.

A more straightforward connection between falling real interest rates and the increase in share of resources employed in winner-take-all markets might be that winner-take-all markets (e.g., most of the financial sector) are somehow diverting those most likely to innovate and generate new productive ideas into socially wasteful activities. That hypothesis certainly seems to accord with the oft-heard observation that, until recently at any rate, a disproportionate share of the best and brightest graduates of elite institutions of higher learning have been finding employment on Wall Street and in hedge funds. If so, the rate of technological advance in the productive sector of the economy would have been less rapid than the rate of advance in the unproductive sector of the economy. Somehow that doesn’t seem like a recipe for increasing the rate of economic growth and might even account for declining real interest rates. Something to think about as you watch the Lance Armstrong interview tomorrow night.

Why Are Real Interest Rates So Low, and Will They Ever Bounce Back?

Published January 9, 2013 expectations , natural rate of unemployment , real interest rates , Scott Sumner 26 Comments
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In his recent post commenting on the op-ed piece in the Wall Street Journal by Michael Woodford and Frederic Mishkin on nominal GDP level targeting (hereinafter NGDPLT), Scott Sumner made the following observation.

I would add that Woodford’s preferred interest rate policy instrument is also obsolete.  In the next recession, and probably the one after that, interest rates will again fall to zero.  Indeed the only real suspense is whether they’ll be able to rise significantly above zero before the next recession hits.  In the US in 1937, Japan in 2001, and the eurozone in 2011, rates had barely nudged above zero before the next recession hit. Ryan Avent has an excellent post discussing this issue.

Perhaps I am misinterpreting him, but Scott seems to think that the decline in real interest rates reflects some fundamental change in the economy since approximately the start of the 21st century. Current low real rates, below zero on US Treasuries well up the yield curve. The real rate is unobservable, but it is related to (but not identical with) the yield on TIPS which are now negative up to 10-year maturities. The fall in real rates partly reflects the cyclical tendency for the expected rate of return on new investment to fall in recessions, but real interest rates were falling even before the downturn started in 2007.

In this post, at any rate, Scott doesn’t explain why the real rate of return on investment is falling. In the General Theory, Keynes speculated about the possibility that after the great industrialization of the 19th and early 20th centuries, new opportunities for investment were becoming exhausted. Alvin Hansen, an early American convert to Keynesianism, developed this idea into what he called the secular-stagnation hypothesis, a hypothesis suggesting that, after World War II, even with very low interest rates, the US economy was likely to relapse into depression. The postwar boom seemed to disprove Hansen’s idea, which became a kind of historical curiosity, if not an embarrassment. I wonder if Scott thinks that Keynes and Hansen were just about a half-century ahead of their time, or does he have some other reason in mind for why he thinks that real interest rates are destined to be very low?

One possibility, which, in a sense, is the optimistic take on our current predicament, is that low real interest rates are the result of bad monetary policy, the obstacle to an economic expansion that, in the usual course of events, would raise real interest rates back to more “normal” levels. There are two problems with this interpretation. First, the decline in real interest rates began in the last decade well before the 2007-09 downturn. Second, why does Scott, evidently accepting Ryan Avent’s pessimistic assessment of the life-expectancy of the current recovery notwithstanding rapidly increasing support for NGDPLT, anticipate a relapse into recession before the recovery raises real interest rates above their current near-zero levels? Whatever the explanation, I look forward to hearing more from Scott about all this.

But in the meantime, here are some thoughts of my own about our low real interest rates.

First, it can’t be emphasized too strongly that low real interest rates are not caused by Fed “intervention” in the market. The Fed can buy up all the Treasuries it wants to, but doing so could not force down interest rates if those low interest rates were inconsistent with expected rates of return on investment and the marginal rate of time preference of households. Despite low real interest rates, consumers are not rushing to borrow money at low rates to increase present consumption, nor are businesses rushing to take advantage of low real interest rates to undertake shiny new investment projects. Current low interest rates are a reflection of the expectations of the public about their opportunities for trade-offs between current and future consumption and between current and future production and their expectations about future price levels and interest rates. It is not the Fed that is punishing savers, as the editorial page of the Wall Street Journal constantly alleges. Rather, it is the distilled wisdom of market participants that is determining how much any individual should be rewarded for the act of abstaining from current consumption. Unfortunately, there is so little demand for resources to be used to increase future output, the act of abstaining from current consumption contributes essentially nothing, at the margin, to the increase of future output, which is why the market is now offering next to no reward for a marginal abstention from current consumption.

Second, interest rates reflect the expectations of businesses and investors about the profitability of investing in new capital, and the expectations of households about their future incomes (largely dependent on expectations about future employment). These expectations – about profitability and about future incomes — are distinct, but they are clearly interdependent. If businesses are optimistic about the profitability of future investment, households are likely to be optimistic about future incomes. If households are pessimistic about future incomes, businesses are unlikely to expect investments in new capital to be profitable. If real interest rates are stuck at zero, it suggests that businesses and households are stuck in a mutually reinforcing cycle of pessimistic expectations — households about future income and employment and businesses about the profitability of investing in new capital. Expectations, as I have said before, are fundamental. Low interest rates and secular stagnation need not be the result of an inevitable drying up of investment opportunities; they may be the result of a vicious cycle of mutually reinforcing pessimism by households and businesses.

The simple Keynesian model — at least the Keynesian-cross version of intro textbooks or even the IS-LM version of intermediate textbooks – generally holds expectations constant. But in fact, it is through the adjustment of expectations that full-employment equilibrium is reached. For fiscal or monetary policy to work, they must alter expectations. Conventional calculations of spending or tax multipliers, which implicitly hold expectations constant, miss the point, which is to alter expectations.

Similarly, as I have tried to suggest in my previous two posts, what Friedman called the natural rate of unemployment may itself depend on expectations. A change in monetary policy may alter expectations in a manner that reduces the natural rate. A straightforward application of the natural-rate model leads some to dismiss a reduction in unemployment associated with a small increase in the rate of inflation as inefficient, because the increase in employment results from workers being misled into accepting jobs that will turn out to pay workers a lower real wage than they had expected. But even if that is so, the increase in employment may still be welfare-increasing, because the employment of each worker improves the chances that another worker will become employed. The social benefit of employment may be greater than the private benefit. In that case, the apparent anomaly (from the standpoint of the natural-rate hypothesis) that measurements of social well-being seem to be greatest when employment is maximized actually make perfectly good sense.

In an upcoming post, I hope to explore some other possible explanations for low real interest rates.

The Lucas Critique Revisited

Published January 2, 2013 Phillips Curve , Robert Lucas 19 Comments
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After writing my previous post, I reread Robert Lucas’s classic article “Econometric Policy Evaluation: A Critique,” surely one of the most influential economics articles of the last half century. While the main point of the article was not entirely original, as Lucas himself acknowledged in the article, so powerful was his explanation of the point that it soon came to be known simply as the Lucas Critique. The Lucas Critique says that if a certain relationship between two economic variables has been estimated econometrically, policy makers, in formulating a policy for the future, cannot rely on that relationship to persist once a policy aiming to exploit the relationship is adopted. The motivation for the Lucas Critique was the Friedman-Phelps argument that a policy of inflation would fail to reduce the unemployment rate in the long run, because workers would eventually adjust their expectations of inflation, thereby draining inflation of any stimulative effect. By restating the Friedman-Phelps argument as the application of a more general principle, Lucas reinforced and solidified the natural-rate hypothesis, thereby establishing a key principle of modern macroeconomics.

In my previous post I argued that microeconomic relationships, e.g., demand curves and marginal rates of substitution, are, as a matter of pure theory, not independent of the state of the macroeconomy. In an interdependent economy all variables are mutually determined, so there is no warrant for saying that microrelationships are logically prior to, or even independent of, macrorelationships. If so, then the idea of microfoundations for macroeconomics is misleading, because all economic relationships are mutually interdependent; some relationships are not more basic or more fundamental than others. The kernel of truth in the idea of microfoundations is that there are certain basic principles or axioms of behavior that we don’t think an economic model should contradict, e.g., arbitrage opportunities should not be left unexploited – people should not pass up obvious opportunities, such as mutually beneficial offers of exchange, to increase their wealth or otherwise improve their state of well-being.

So I was curious to how see whether Lucas, while addressing the issue of how price expectations affected output and employment, recognized the possibility that a microeconomic relationship could be dependent on the state of the macroeconomy, . For my purposes, the relevant passage occurs in section 5.3 (subtitled “Phillips Curves”) of the paper. After working out the basic theory earlier in the pape, Lucas, in section 5 provided three examples of how econometric estimates of macroeconomic relationships would mislead policy makers if the effect of expectations on those relationships were not taken into account. The first two subsections treated consumption expenditures and the investment tax credit. The passage that I want to focus on consists of the first two paragraphs of subsection 5.3 (which I now quote verbatim except for minor changes in Lucas’s notation).

A third example is suggested by the recent controversy over the Phelps-Friedman hypothesis that permanent changes in the inflation rate will not alter the average rate of unemployment. Most of the major econometric models have been used in simulation experiments to test this proposition; the results are uniformly negative. Since expectations are involved in an essential way in labor and product market supply behavior, one would presumed, on the basis of the considerations raised in section 4, that these tests are beside the point. This presumption is correct, as the following example illustrates.

It will be helpful to utilize a simple, parametric model which captures the main features of the expectational view of aggregate supply – rational agents, cleared markets, incomplete information. We imagine suppliers of goods to be distributed over N distinct markets i, I = 1, . . ., N. To avoid index number problems, suppose that the same (except for location) good is traded in each market, and let y_it be the log of quantity supplied in market i in period t. Assume, further, that the supply y_it is composed of two factors

y_it = Py_it + Cy_it,

where Py_it denotes normal or permanent supply, and Cy_it cyclical or transitory supply (both again in logs). We take Py_it to be unresponsive to all but permanent relative price changes or, since the latter have been defined away by assuming a single good, simply unresponsive to price changes. Transitory supply Cy_it varies with perceived changes in the relative price of goods in i:

Cy_it = β(p_it – Ep_it),

where p_it is the log of the actual price in i at time t, and Ep_it is the log of the general (geometric average) price level in the economy as a whole, as perceived in market i.

Let’s take a moment to ponder the meaning of Lucas’s simplifying assumption that there is just one good. Relative prices (except for spatial differences in an otherwise identical good) are fixed by assumption; a disequilibrium (or suboptimal outcome) can arise only because of misperceptions of the aggregate price level. So, by explicit assumption, Lucas rules out the possibility that any microeconomic relationship depends on macroeconomic conditions. Note also that Lucas does not provide an account of the process by which market prices are established at each location, nothing being said about demand conditions. For example, if suppliers at location i perceive a price (transitorily) above the equilibrium price, and respond by (mistakenly) increasing output, thereby increasing their earnings, do those suppliers increase their demand to consume output? Suppose suppliers live and purchase at locations other than where they are supplying product, so that a supplier at location i purchases at location j, where i does not equal j. If a supplier at location i perceives an increase in price at location i, will his demand to purchase the good at location j increase as well? Will the increase in demand at location j cause an increase in the price at location j? What if there is a one-period lag between supplier receipts and their consumption demands? Lucas provides no insight into these possible ambiguities in his model.

Stated more generally, the problem with Lucas’s example is that it seems to be designed to exclude a priori the possibility of every type of disequilibrium but one, a disequilibrium corresponding to a single type of informational imperfection. Reasoning on the basis of that narrow premise, Lucas shows that, under a given expectation of the future price level, an econometrician would find a positive correlation between the price level and output — a negatively sloped Phillips Curve. Yet, under the same assumptions, Lucas also shows that an anticipated policy to raise the rate of inflation would fail to raise output (or, by implication, increase employment). But, given his very narrow underlying assumptions, it seems plausible to doubt the robustness of Lucas’s conclusion. Proving the validity of a proposition requires more than constructing an example in which the proposition is shown to be valid. That would be like trying to prove that the sides of every triangle are equal in length by constructing a triangle whose angles are all equal to 60 degrees, and then claiming that, because the sides of that triangle are equal in length, the sides of all triangles are equal in length.

Perhaps a better model than the one Lucas posited would have been one in which the amount supplied in each market was positively correlated with the amount supplied in every other market, inasmuch as an increase (decrease) in the amount supplied in one market will tend to increase (decrease) demand in other markets. In that case, I conjecture, deviations from permanent supply would tend to be cumulative (though not necessarily permanent), implying a more complex propagation mechanism than Lucas’s simple model does. Nor is it obvious to me how the equilibrium of such a model would compare to the equilibrium in the Lucas model. It does not seem inconceivable that a model could be constructed in which equilibrium output depended on the average price level. But this is just conjecture on my part, because I haven’t tried to write out and solve such a model. Perhaps an interested reader out there will try to work it out and report back to us on the results.

PS:  Congratulations to Scott Sumner on his excellent op-ed on nominal GDP level targeting in today’s Financial Times.

The State We’re In

Published December 25, 2012 expectations , Friedman , Kenneth Carlaw , macroeconomics , Paul Krugman , R. G. Lipsey , rational expectations , Robert Lucas , Scott Sumner , Stephen Williamson 44 Comments
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Last week, Paul Krugman, set off by this blog post, complained about the current state macroeconomics. Apparently, Krugman feels that if saltwater economists like himself were willing to accommodate the intertemporal-maximization paradigm developed by the freshwater economists, the freshwater economists ought to have reciprocated by acknowledging some role for countercyclical policy. Seeing little evidence of accommodation on the part of the freshwater economists, Krugman, evidently feeling betrayed, came to this rather harsh conclusion:

The state of macro is, in fact, rotten, and will remain so until the cult that has taken over half the field is somehow dislodged.

Besides engaging in a pretty personal attack on his fellow economists, Krugman did not present a very flattering picture of economics as a scientific discipline. What Krugman describes seems less like a search for truth than a cynical bargaining game, in which Krugman feels that his (saltwater) side, after making good faith offers of cooperation and accommodation that were seemingly accepted by the other (freshwater) side, was somehow misled into making concessions that undermined his side’s strategic position. What I found interesting was that Krugman seemed unaware that his account of the interaction between saltwater and freshwater economists was not much more flattering to the former than the latter.

Krugman’s diatribe gave Stephen Williamson an opportunity to scorn and scold Krugman for a crass misunderstanding of the progress of science. According to Williamson, modern macroeconomics has passed by out-of-touch old-timers like Krugman. Among modern macroeconomists, Williamson observes, the freshwater-saltwater distinction is no longer meaningful or relevant. Everyone is now, more or less, on the same page; differences are worked out collegially in seminars, workshops, conferences and in the top academic journals without the rancor and disrespect in which Krugman indulges himself. If you are lucky (and hard-working) enough to be part of it, macroeconomics is a great place to be. One can almost visualize the condescension and the pity oozing from Williamson’s pores for those not part of the charmed circle.

Commenting on this exchange, Noah Smith generally agreed with Williamson that modern macroeconomics is not a discipline divided against itself; the intetermporal maximizers are clearly dominant. But Noah allows himself to wonder whether this is really any cause for celebration – celebration, at any rate, by those not in the charmed circle.

So macro has not yet discovered what causes recessions, nor come anywhere close to reaching a consensus on how (or even if) we should fight them. . . .

Given this state of affairs, can we conclude that the state of macro is good? Is a field successful as long as its members aren’t divided into warring camps? Or should we require a science to give us actual answers? And if we conclude that a science isn’t giving us actual answers, what do we, the people outside the field, do? Do we demand that the people currently working in the field start producing results pronto, threatening to replace them with people who are currently relegated to the fringe? Do we keep supporting the field with money and acclaim, in the hope that we’re currently only in an interim stage, and that real answers will emerge soon enough? Do we simply conclude that the field isn’t as fruitful an area of inquiry as we thought, and quietly defund it?

All of this seems to me to be a side issue. Who cares if macroeconomists like each other or hate each other? Whether they get along or not, whether they treat each other nicely or not, is really of no great import. For example, it was largely at Milton Friedman’s urging that Harry Johnson was hired to be the resident Keynesian at Chicago. But almost as soon as Johnson arrived, he and Friedman were getting into rather unpleasant personal exchanges and arguments. And even though Johnson underwent a metamorphosis from mildly left-wing Keynesianism to moderately conservative monetarism during his nearly two decades at Chicago, his personal and professional relationship with Friedman got progressively worse. And all of that nastiness was happening while both Friedman and Johnson were becoming dominant figures in the economics profession. So what does the level of collegiality and absence of personal discord have to do with the state of a scientific or academic discipline? Not all that much, I would venture to say.

So when Scott Sumner says:

while Krugman might seem pessimistic about the state of macro, he’s a Pollyanna compared to me. I see the field of macro as being completely adrift

I agree totally. But I diagnose the problem with macro a bit differently from how Scott does. He is chiefly concerned with getting policy right, which is certainly important, inasmuch as policy, since early 2008, has, for the most part, been disastrously wrong. One did not need a theoretically sophisticated model to see that the FOMC, out of misplaced concern that inflation expectations were becoming unanchored, kept money way too tight in 2008 in the face of rising food and energy prices, even as the economy was rapidly contracting in the second and third quarters. And in the wake of the contraction in the second and third quarters and a frightening collapse and panic in the fourth quarter, it did not take a sophisticated model to understand that rapid monetary expansion was called for. That’s why Scott writes the following:

All we really know is what Milton Friedman knew, with his partial equilibrium approach. Monetary policy drives nominal variables.  And cyclical fluctuations caused by nominal shocks seem sub-optimal.  Beyond that it’s all conjecture.

Ahem, and Marshall and Wicksell and Cassel and Fisher and Keynes and Hawtrey and Robertson and Hayek and at least 25 others that I could easily name. But it’s interesting to note that, despite his Marshallian (anti-Walrasian) proclivities, it was Friedman himself who started modern macroeconomics down the fruitless path it has been following for the last 40 years when he introduced the concept of the natural rate of unemployment in his famous 1968 AEA Presidential lecture on the role of monetary policy. Friedman defined the natural rate of unemployment as:

the level [of unemployment] that would be ground out by the Walrasian system of general equilibrium equations, provided there is embedded in them the actual structural characteristics of the labor and commodity markets, including market imperfections, stochastic variability in demands and supplies, the costs of gathering information about job vacancies, and labor availabilities, the costs of mobility, and so on.

Aside from the peculiar verb choice in describing the solution of an unknown variable contained in a system of equations, what is noteworthy about his definition is that Friedman was explicitly adopting a conception of an intertemporal general equilibrium as the unique and stable solution of that system of equations, and, whether he intended to or not, appeared to be suggesting that such a concept was operationally useful as a policy benchmark. Thus, despite Friedman’s own deep skepticism about the usefulness and relevance of general-equilibrium analysis, Friedman, for whatever reasons, chose to present his natural-rate argument in the language (however stilted on his part) of the Walrasian general-equilibrium theory for which he had little use and even less sympathy.

Inspired by the powerful policy conclusions that followed from the natural-rate hypothesis, Friedman’s direct and indirect followers, most notably Robert Lucas, used that analysis to transform macroeconomics, reducing macroeconomics to the manipulation of a simplified intertemporal general-equilibrium system. Under the assumption that all economic agents could correctly forecast all future prices (aka rational expectations), all agents could be viewed as intertemporal optimizers, any observed unemployment reflecting the optimizing choices of individuals to consume leisure or to engage in non-market production. I find it inconceivable that Friedman could have been pleased with the direction taken by the economics profession at large, and especially by his own department when he departed Chicago in 1977. This is pure conjecture on my part, but Friedman’s departure upon reaching retirement age might have had something to do with his own lack of sympathy with the direction that his own department had, under Lucas’s leadership, already taken. The problem was not so much with policy, but with the whole conception of what constitutes macroeconomic analysis.

The paper by Carlaw and Lipsey, which I referenced in my previous post, provides just one of many possible lines of attack against what modern macroeconomics has become. Without in any way suggesting that their criticisms are not weighty and serious, I would just point out that there really is no basis at all for assuming that the economy can be appropriately modeled as being in a continuous, or nearly continuous, state of general equilibrium. In the absence of a complete set of markets, the Arrow-Debreu conditions for the existence of a full intertemporal equilibrium are not satisfied, and there is no market mechanism that leads, even in principle, to a general equilibrium. The rational-expectations assumption is simply a deus-ex-machina method by which to solve a simplified model, a method with no real-world counterpart. And the suggestion that rational expectations is no more than the extension, let alone a logical consequence, of the standard rationality assumptions of basic economic theory is transparently bogus. Nor is there any basis for assuming that, if a general equilibrium does exist, it is unique, and that if it is unique, it is necessarily stable. In particular, in an economy with an incomplete (in the Arrow-Debreu sense) set of markets, an equilibrium may very much depend on the expectations of agents, expectations potentially even being self-fulfilling. We actually know that in many markets, especially those characterized by network effects, equilibria are expectation-dependent. Self-fulfilling expectations may thus be a characteristic property of modern economies, but they do not necessarily produce equilibrium.

An especially pretentious conceit of the modern macroeconomics of the last 40 years is that the extreme assumptions on which it rests are the essential microfoundations without which macroeconomics lacks any scientific standing. That’s preposterous. Perfect foresight and rational expectations are assumptions required for finding the solution to a system of equations describing a general equilibrium. They are not essential properties of a system consistent with the basic rationality propositions of microeconomics. To insist that a macroeconomic theory must correspond to the extreme assumptions necessary to prove the existence of a unique stable general equilibrium is to guarantee in advance the sterility and uselessness of that theory, because the entire field of study called macroeconomics is the result of long historical experience strongly suggesting that persistent, even cumulative, deviations from general equilibrium have been routine features of economic life since at least the early 19th century. That modern macroeconomics can tell a story in which apparently large deviations from general equilibrium are not really what they seem is not evidence that such deviations don’t exist; it merely shows that modern macroeconomics has constructed a language that allows the observed data to be classified in terms consistent with a theoretical paradigm that does not allow for lapses from equilibrium. That modern macroeconomics has constructed such a language is no reason why anyone not already committed to its underlying assumptions should feel compelled to accept its validity.

In fact, the standard comparative-statics propositions of microeconomics are also based on the assumption of the existence of a unique stable general equilibrium. Those comparative-statics propositions about the signs of the derivatives of various endogenous variables (price, quantity demanded, quantity supplied, etc.) with respect to various parameters of a microeconomic model involve comparisons between equilibrium values of the relevant variables before and after the posited parametric changes. All such comparative-statics results involve a ceteris-paribus assumption, conditional on the existence of a unique stable general equilibrium which serves as the starting and ending point (after adjustment to the parameter change) of the exercise, thereby isolating the purely hypothetical effect of a parameter change. Thus, as much as macroeconomics may require microfoundations, microeconomics is no less in need of macrofoundations, i.e., the existence of a unique stable general equilibrium, absent which a comparative-statics exercise would be meaningless, because the ceteris-paribus assumption could not otherwise be maintained. To assert that macroeconomics is impossible without microfoundations is therefore to reason in a circle, the empirically relevant propositions of microeconomics being predicated on the existence of a unique stable general equilibrium. But it is precisely the putative failure of a unique stable intertemporal general equilibrium to be attained, or to serve as a powerful attractor to economic variables, that provides the rationale for the existence of a field called macroeconomics.

So I certainly agree with Krugman that the present state of macroeconomics is pretty dismal. However, his own admitted willingness (and that of his New Keynesian colleagues) to adopt a theoretical paradigm that assumes the perpetual, or near-perpetual, existence of a unique stable intertemporal equilibrium, or at most admits the possibility of a very small set of deviations from such an equilibrium, means that, by his own admission, Krugman and his saltwater colleagues also bear a share of the responsibility for the very state of macroeconomics that Krugman now deplores.

Carlaw and Lipsey on Whether History Matters

Published December 22, 2012 Kenneth Carlaw , macroeconomics , R. G. Lipsey 12 Comments
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About six months ago,  I mentioned a forthcoming paper by Kenneth Carlaw and Richard Lipsey, “Does history matter? Empirical analysis  of evolutionary versus stationary equilibrium views of the economy.”  The paper was recently published in the Journal of Evolutionary Economics.  The empirical analysis undertaken by Carlaw and Lipsey undermines many widely accepted propositions of modern macroeconomics, and is thus especially timely after the recent flurry of posts on the current state of macroecoomics by Krugman, Williamson, Smith, Delong, Sumner, et al., a topic about which I may have a word or two to say anon.  Here is the abstract of the Carlaw and Lipsey paper.

The evolutionary vision in which history matters is of an evolving economy driven by bursts of technological change initiated by agents facing uncertainty and producing long term, path-dependent growth and shorter-term, non-random investment cycles. The alternative vision in which history does not matter is of a stationary, ergodic process driven by rational agents facing risk and producing stable trend growth and shorter term cycles caused by random disturbances. We use Carlaw and Lipsey’s simulation model of non-stationary, sustained growth driven by endogenous, path-dependent technological change under uncertainty to generate artificial macro data. We match these data to the New Classical stylized growth facts. The raw simulation data pass standard tests for trend and difference stationarity, exhibiting unit roots and cointegrating processes of order one. Thus, contrary to current belief, these tests do not establish that the real data are generated by a stationary process. Real data are then used to estimate time-varying NAIRU’s for six OECD countries. The estimates are shown to be highly sensitive to the time period over which they are made. They also fail to show any relation between the unemployment gap, actual unemployment minus estimated NAIRU and the acceleration of inflation. Thus there is no tendency for inflation to behave as required by the New Keynesian and earlier New Classical theory. We conclude by rejecting the existence of a well-defined a short-run, negatively sloped Philips curve, a NAIRU, a unique general equilibrium, short and long-run, a vertical long-run Phillips curve, and the long-run neutrality of money.

UPDATE:  In addition to the abstract, I think it would be worthwhile to quote the three introductory paragraphs from Carlaw and Lipsey.

Economists face two conflicting visions of the market economy, visions that reflect two distinct paradigms, the Newtonian and the Darwinian. In the former, the behaviour of the economy is seen as the result of an equilibrium reached by the operation of opposing forces – such as market demanders and suppliers or competing oligopolists – that operate in markets characterised by negative feedback that returns the economy to its static equilibrium or its stationary equilibrium growth path. In the latter, the behaviour of the economy is seen as the result of many different forces – especially technological changes – that evolve endogenously over time, that are subject to many exogenous shocks, and that often operate in markets subject to positive feedback and in which agents operate under conditions of genuine uncertainty.
One major characteristic that distinguishes the two visions is stationarity for the Newtonian and non-stationarity for the Darwinian. In the stationary equilibrium of a static general equilibrium model and the equilibrium growth path of a Solow-type or endogenous growth model, the path by which the equilibrium is reached has no effect on the equilibrium values themselves. In short, history does not matter. In contrast, an important characteristic of the Darwinian vision is path dependency: what happens now has important implications for what will happen in the future. In short, history does matter.
In this paper, we consider, and cast doubts on, the stationarity properties of models in the Newtonian tradition. These doubts, if sustained, have important implications for understanding virtually all aspects of macroeconomics, including of long term economic growth, shorter term business cycles, and stabilisation policy.
UPDATE (12/28/12):  I received an email from Richard Lipsey about this post.  He attached two footnotes (1 and 5) from his article with Carlaw, which he thinks are relevant to some of the issues raised in comments to this post.  Footnote 1 explains their use of “Darwinian” to describe their path-dependent approach to economic modeling; footnote 5 observes that the analysis of many microeconomic problems and short-run macro-policy analysis may be amenable to the static-equilibrium method.

1 The use of the terms Darwinian and Newtonian here is meant to highlight the significant difference in equilibrium concept employed in the two groups of theories that we contrast, the evolutionary and what we call equilibrium with deviations (EWD) theories. Not all evolutionary theories, including the one employed here, are strictly speaking Darwinian in the sense that they embody replication and selection. We use the term, Darwinian to highlight the critical equilibrium concept of a path dependent, non-ergodic, historical process employed in Darwinian and evolutionary theories and to draw the contrast between that and the negative feedback, usually unique, ergodic equilibrium concept employed in Newtonian and EWD theories.

 5 Most evolutionary economists accept that for many issues in micro economics, comparative static equilibrium models are useful. Also, there is nothing incompatible between the evolutionary world view and the use of Keynesian models – of which IS-LM closed by an expectations-augmented Phillips curve is the prototype – to study such short run phenomenon as stagflation and the impact effects of monetary and fiscal policy shocks. Problems arise, however, when such analyses are applied to situations in which technology is changing endogenously over time periods that are relevant to the issues being studied. Depending on the issue at hand, this might be as short as a few months.

Maybe Robert Waldmann Should Calm Down

Published December 18, 2012 expectations , inflation , monetary policy , zero lower bound 7 Comments
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Robert Waldmann is unhappy with Matthew Yglesias for being hopeful that, Shinzo Abe, just elected prime minister of Japan, may be about to make an important contribution to the world economy, and to economic science, by prodding the Bank of Japan to increase its inflation target and by insisting that the BOJ actually hit the new target. Since I don’t regularly read Waldmann’s blog (not because it’s not worth reading — I usually enjoy reading it when I get to it – I just can’t keep up with that many blogs), I’m not sure why Waldmann finds Yglesias’s piece so annoying. OK, Waldmann’s a Keynesian and prefers fiscal to monetary policy, but so is Paul Krugman, and he thinks that monetary policy can be effective even at the zero lower bound. At any rate this is how Waldmann responds to Yglesias:

Ben Bernanke too has declared a policy of unlimited quantitative easing and increased inflation (new target only 2.5% but that’s higher than current inflation).  The declaration (which was a surprise) had essentially no effect on prices for medium term treasuries, TIPS or the breakeven.

I was wondering when you would comment, since you have confidently asserted again and again that if only the FOMC did what it just did, expected inflation would jump and then GDP growth would increase.

However, instead of noting the utter total failure of your past predictions (and the perfect confirmation of mine) you just boldly make new predictions.

Face fact,  like conventional monetary policy (in the US the Federal Funds rate) forward guidance is pedal to the metal.   It’s long past time for you to start climbing down.

I mention this, because just yesterday I happened across another blog post about what Bernanke said after the FOMC meeting.  This post by David Altig, executive VP and research director of the Atlanta Fed, was on the macroblog. Altig points out that, despite the increase in the Fed’s inflation threshold from 2 to 2.5%, the Fed increased neither its inflation target (still 2%) nor its inflation forecast (still under 2%). All that the Fed did was to say that it won’t immediately slam on the brakes if inflation rises above 2% provided that unemployment is greater than 6.5% and inflation is less than 2.5%. That seems like a pretty marginal change in policy to me.

Also have a look at this post from earlier today by Yglesias, showing that the Japanese stock market has risen about 5.5% in the last two weeks, and about 2% in the two days since Abe’s election. Here is Yglesias’s chart showing the rise of the Nikkei over the past two weeks.

abe-nomics

In addition, here is a news story from Bloomberg about rising yields on Japanese government bonds, which are now the highest since April.

Japan‘s bonds declined, sending 20- year yields to an eight-month high, as demand ebbed at a sale of the securities and domestic shares climbed.

The sale of 1.2 trillion yen ($14.3 billion) of 20-year bonds had the lowest demand in four months. Yields on the benchmark 10-year note rose to a one-month high as Japan’s Nikkei 225 Stock Average reached the most since April amid signs U.S. budget talks are progressing.

Finally, another item from Yglesias, a nice little graph showing the continuing close relationship between the S&P 500 and inflation expectations as approximated by the breakeven TIPS spread on 10-year Treasuries, a relationship for which I have provided (in a paper available here) a theoretical explanation as well as statistical evidence that the relationship did not begin to be observed until approximately the spring of 2008 as the US economy, even before the Lehman debacle, began its steep contraction. Here’s the graph.

yglesias_S&P500

HT: Mark Thoma

UPDATE:  Added a link above to the blog post by Altig about what Bernanke meant when he announced a 2.5% inflation threshold.

The Prodigal Son Returns: The Wall Street Journal Editorial Page Rediscovers Root Canal Economics

Published December 17, 2012 Bernanke , monetary policy 14 Comments
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Perhaps the most interesting and influential financial journalist of the 1970s was a guy by the name of Jude Wanniski, who was an editorial writer for Wall Street Journal, from 1972 to 1978. In the wake of the Watergate scandal, and the devastating losses suffered by the Republicans in the 1974 Congressional elections, many people thought that the Republican party might not survive. The GOP certainly did not seem to offer much hope for free-market conservatives and libertarians, Richard Nixon having imposed wage-and-price controls in 1971, with the help of John Connally and Arthur Burns and enthusiastic backing from almost all Republicans. After Nixon resigned, leadership of the party was transferred to his successor, Gerald Ford, a very nice and decent fellow, whose lack of ideological conviction was symbolized by his choice of Nelson Rockefeller, an interventionist, big-government Republican if there ever was one, to serve as his Vice-President.

In this very dispirited environment for conservatives, Jude Wanniski’s editorial pieces in the Wall Street Journal and his remarkable 1978 book The Way the World Works, in which he advocated cuts in income tax rates as a cure for economic stagnation, proved to be an elixir of life for demoralized Republicans and conservatives. Wanniski was especially hard on old-fashioned Republicans and conservatives for whom balancing the federal budget had become the be all and end of all of economic policy, a doctrine that the Wall Street Journal itself had once espoused. A gifted phrase maker, Wanniski dubbed traditional Republican balanced-budget policy, root-canal economics. Instead, Wanniski adopted the across-the-board income tax cuts proposed by John Kennedy in 1963, a proposal that conservative icon Barry Goldwater had steadfastly opposed, as his model for economic policy.

Wanniski quickly won over a rising star in the Republican party, former NFL quarterback Jack Kemp, to his way of thinking.  Another acolyte was an ambitious young Georgian by the name of Newt Gingrich. In 1978, Kemp and Senator Bill Roth form Delaware (after whom the Roth IRA is named), co-authored a bill, without support from the Republican Congressional leadership, to cut income taxes across the board by 25%. Many Republicans running for Congress and the Senate in 1978 pledged to support what became known as the Kemp-Roth bill. An unexpectedly strong showing by Republicans supporting the Kemp-Roth bill in the 1978 elections encouraged Jack Kemp to consider running for President in 1980 on a platform of across-the-board tax cuts. However, when Ronald Reagan, nearly 70 years old, and widely thought, after unsuccessfully challenging Gerald Ford for the GOP nomination in 1976, to be past his prime, signed on as a supporter of the Kemp-Roth bill, Kemp bowed out of contention, endorsing Reagan for the nomination, and uniting conservatives behind the Gipper.

After his landslide victory in the 1980 election, Reagan, riding a crest of popularity, enhanced by an unsuccessful assassination attempt in the first few months of his term, was able to push the Kemp-Roth bill through Congress, despite warnings from the Democrats that steep tax cuts would cause large budget deficits. To such warnings, Jack Kemp famously responded that Republicans no longer worshiped at the altar of a balanced budget. No one cheered louder for that heretical statement by Kemp than, you guessed it, the Wall Street Journal editorial page.

Fast forward to 2012, the Wall Street Journal, which never fails to invoke the memory of Ronald Reagan whenever an opportunity arises, nevertheless seems to have rediscovered the charms of root-canal economics. How else can one explain this piece of sophistry from Robert L. Pollock, a member of the group of sages otherwise known as the Editorial Board of the Wall Street Journal? Consider what Mr. Pollock had to say in an opinion piece on the Journal‘s website.

[T]o the extent that the United States finds itself in a precarious fiscal situation, Federal Reserve Chairman Ben Bernanke shares much of the blame. Simply put, there is no way that Washington could have run the deficits it has in recent years without the active assistance of a near-zero interest rate policy. . . .

European governments finally decided to take cost-cutting steps when their borrowing costs went up. But Democrats and liberal economists use Mr. Bernanke’s low rates and willingness to buy government bonds as evidence that there’s no pressing problem here to be addressed.

This is a strange argument for high interest rates, especially coming from a self-avowed conservative. Conservatives got all bent out of shape when Obama’s Energy Secretary, Stephen Chu, opined that rising gasoline prices might actually serve a useful function by inducing consumers and businesses to be more economical in their their use of gasoline. That comment was seized on by Republicans as proof that the Obama administration was seeking to increase gasoline prices as a way of reducing gasoline consumption. Now, Mr. Pollock provides us with a new argument for high interest rates: by raising the cost of borrowing, high interest rates will force the government to be more economical in its spending decisions.  Evidently, it’s wrong to suggest that an increased price will reduce gasoline consumption, but it’s fine to say that an increased interest rate will cut government spending. Go figure.

Well, here’s what Wanniski had to say about the Republican obsession with reducing government spending for its own sake:

It isn’t that Republicans don’t enjoy cutting taxes. They love it. But there is something in the Republican chemistry that causes the GOP to become hypnotized by the prospect of an imbalanced budget. Static analysis tells them taxes can’t be cut or inflation will result. They either argue for a tax hike to dampen inflation when the economy is in a boom or demand spending cuts to balance the budget when the economy is in recession.

Either way, of course, they embrace the role of Scrooge, playing into the hands of the Democrats, who know the first rule of successful politics is Never Shoot Santa Claus. The political tension in the market place of ideas must be between tax reduction and spending increases, and as long as Republicans have insisted on balanced budgets, their influence as a party has shriveled, and budgets have been imbalanced.

How’s that old root-canal economics working out for ya?

Now back to Pollock. Here’s how he explains why low interest rates may not really be helping the economy.

It would be one thing if there were widespread agreement that low rates are the right medicine for the economy. But easy money on the Bernanke scale is a heretofore untested policy, one for which the past few years of meager growth haven’t provided convincing evidence.

Fair enough. Low rates haven’t been helping the economy all that much. But the question arises: why are rates so low? Is it really all the Fed’s doing, or could it possibly have something to do with pessimism on the part of businesses and consumers about whether they will be able to sell their products or their services in the future? If it is the latter, then low interest rates may not be a symptom of easy money, but of tight money.

Pollock, of course, has a different explanation for why low interest rates are not promoting a recovery.

Economists such as David Malpass argue that low rates are actually contractionary because they cause capital to be diverted from more productive uses to less productive ones.

Oh my. What can one say about an argument like that? I have encountered Mr. Malpass before and was less than impressed by his powers of economic reasoning; I remain unimpressed. How can a low interest rate divert capital from more productive uses to less productive ones unless capital rationing is taking place? If some potential borrowers were unable to secure funding for their productive projects while other borrowers with less productive projects were able to get funding for theirs, the disappointed borrowers could have offered to borrow at increased interest rates, thereby outbidding borrowers with unproductive projects, and driving up interest rates in the process.   That is just elementary.  That interest rates are now at such low levels is more reflective of the pessimism of most potential borrowers about the projects for which they seeking funding, than of the supposed power of the Fed to determine interest rates.

So there you have it. The Wall Street Journal editorial page, transformed in the 1970s by the daring and unorthodox ideas of a single, charismatic economic journalist, Jude Wanniski, has now, almost four decades later, finally come back to its roots.  Welcome home where you belong.

About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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