Already in sequestration mode

If you check out the current fiscal stance it is hard not to conclude that we have been under a sort of sequestration mode for a while. Graph below shows the quarterly percent change in total government spending with respect to the previous year.

Note that the numbers have been negative in the last few quarters. This is the result of what Krugman correctly points out in his NYTimes column today, the existence of a growing consensus, since the crisis broke in late 2007, "that fiscal austerity was the appropriate response to an economic crisis caused by runaway bankers." A very short lived Keynesian recovery was allowed, but what really precluded a new Great Depression where automatic stabilizers.

I think that it's very unlikely that the fact that Bernanke, and Stiglitz, as Krugman points out, are for more fiscal stimulus will have any significant impact. I would also add that in part those reasonable New Keynesians (like the ones Krugman cites and himself) that complain about the fact that unreasonable people have taken over not just economic policy, but also the profession, are also partly to blame. You cannot argue that "Joseph Stiglitz, a Nobel laureate and legendary economic theorist whose vocal criticism of our deficit obsession has nonetheless been ignored," without noticing that Bob Lucas, an equally well regarded and Nobel (Sveriges Riksbank Prize) laureate is against deficits.

What's the deal with PPP?

In a previous post I suggested that there might some problems with using Purchasing Power Parity (PPP) measures of income per capita, the traditional measure of well-being used by the World Bank, for example. And although some might think that the main problems are basically empirical, my fundamental preoccupation is theoretical (see this paper, which in fact comes from my thesis).

PPP was developed by Gustav Cassel as an extension of the Quantity Theory of Money (QTM) to international matters. The quantity of money determined domestically the internal price level, and the exchange rate was determined as the ratio of domestic and foreign prices (or vice versa depending on how you define the exchange ratio), or in dynamic versions, the change in the exchange rate was defined as the difference of the inflation rates.

Wicksell was very critical of Cassel's theory, as I note in my paper [there were significant personal differences between the two main authors of the Swedish school, beyond their divergences on economic theory]. He basically suggested that the rate of interest, the natural rate determined by the productivity of capital and the savings decisions of economic agents, was the key variable, not the money supply. Hence, the bank rate, if it was lower than the natural rate, would not only generate his famous cumulative process of inflation, but it would also lead to flows of capital, provided that it was not in line with the bank rate of interest in other countries, and would basically determined the foreign exchange rate [note that Wicksell, and not the Keynes of the Tract, as is often argued, is the first, in 1919, to defend what we would today refer to as the uncovered interest parity condition].

From our perspective what matters here is that, even within the marginalist approach, the notion that the Quantity of Money, and prices, determine the equilibrium exchange rate is ultimately incorrect, once money is endogenous, as Wicksell assumed [note that the modern consensus in macroeconomics, both the New Keynesians and the so-called New Neoclassical Synthesis, assume an exogenous rate of interest, using some sort of rule, typically a variation of Taylor's rule]. Further, if we assume free capital movement, which implies a uniform rate of profit, marginalism would require that capital would flow to places in which it is scarce, and eventually (in the long run) the rate of profit or the natural rate of interest would be equalized.* Hence, the exchange rate that would be establish after the process is complete, would correspond to the uniform natural rate, which governs the bank rate, which as we saw is what Wicksell suggested determines exchange rate. So there must exist a natural exchange rate that corresponds to the natural rate of interest (and the natural rate of unemployment and its correspondent real wage, Friedman would argue).

It is obvious that there are 'imperfections' and the natural rate of interest is not equalized in the real world, so the exchange rate also deviates from the natural rate. But that isn't the main problem with the mainstream view. As we saw, the capital debates undermine the theoretical basis for a natural rate of interest, and hence for a natural exchange rate (or a natural rate of unemployment for that matter). Hence, it is the Keynesian (and Sraffian) institutional rate of interest, as determined by monetary authorities that rules the roost. The conventional rate of interest is then connected to a conventional exchange rate [then institutional factors become relevant, like the existence or not of capital controls, etc.].

Leave aside the theoretical problems of purchasing power parity measures, since they are NOT attractors of the actual exchange rates [the reasons why Argentina had a 1 to 1 exchange rate with the dollar for a decade, or Greece has a 'fixed' parity too are political and institutional], and even if for some purposes you may want to use PPP rates as a measure of material welfare, one may also be interested in actual market exchange rates for other purposes. Indeed, for most of the relevant matters that concern economic well being, particularly in peripheral countries, like the capacity to repay foreign debt and avoid default and import capital goods to promote growth, it is the market exchange rate that is central to convert incomes in different countries into a common numeraire.**

* The fact that capital does NOT flow to developing countries is something that still puzzles very much mainstream economists like Robert Lucas (see here).

** Which means that China is considerably less developed than Argentina and Brazil, even if it is growing fast, it has a regional hegemonic project, and is, by sheer size, one of the most important economies in the world.

Lucas in retrospect

I said it before, but it's worth repeating when one discusses the so-called Lucas' Critique and microfoundations. Lucas and the New Classical Rational Expectations (and RBC) School are the intelligent design of economics. In their view, markets work and this must be the result of some sort of high power, with which mere mortals and governments should not interfere. Lucas and his followers should have the same status as defenders of intelligent design in the scientific community (for the original claim go here).

If you have any doubts go check his paper on what should be the priorities of macroeconomic research just a few years before the crisis (Lucas, 2003), when several heterodox economists had already warned about a bubble and impending crisis. In his own words:

"My thesis in this lecture is that macroeconomics in this original sense has succeeded: Its central problem of depression-prevention has been solved, for all practical purposes, and has in fact been solved for many decades. There remain important gains in welfare from better fiscal policies, but I argue that these are gains from providing people with better incentives to work and to save, not from better fine tuning of spending flows."

Yes, business cycles problems have been solved, and there is no need for counter-cyclical fiscal policy. And this guy got the Sveriges Riksbank Prize, sometimes referred to as the Nobel!

But the point I wanted to make really is that there is less than meets the eye to the so-called Lucas' critique. The problem for Lucas was that the parameters of macroeconometric models (mostly of the Cowles Commission, CC, or the Cambridge-Levy stock flow with coherent accounting, SFCA, types) were not invariant to policy changes, and could not, in fact, be taken as parameters. Even if you take the neoclassical/marginalist approach seriously (meaning forget its logical problems revealed by the capital debates), as noted by Ray Fair (2012) (one of the last defenders of the CC approach within the mainstream):

"The Lucas (1976) critique says that the coefficients may not be stable if they are based on expectations that change over time or change when a new policy regime replaces an old one. This problem is part of the larger problem of potential coefficient instability, and it may not be the most serious. If expectations are not rational or if regimes do not change very often or by very much, any instability caused by Lucas-critique related issues may be small relative to instabilities caused by other things, like the changing age distribution of the population."

The fact, is that parameters are to a great extent invariant to policy changes, and there are a lot of parametrical regularities in macroeconomics, e.g. Okun's Law, Houthakker-Magee effect, or relations with changes in size that are not dramatic, like the size of fiscal multipliers, accelerator coefficients and pass-through effects, for example. And you can go on, for example, it's not a new thing that expansionary fiscal policy and higher debt levels have almost no impact on interest rates, that is, also, a fairly established macro regularity. That is why one can talk about macroeconomic stylized facts.

And it should be no surprise then, that models that do not use the mainstream assumptions of reversion to mean (to the optimal levels, by the way, the reason why Lucas thought cycles were solved and no macro policies where needed), and that depend on the macro accounting and the proper Keynesian causalities fared better during the last crisis (see here).

A Critique of the Lucas Critique

The blogosphere, it seems recently, has been particularly rich in blogoyakking (sp?) concerning microfoundations. Wren-Lewis, Noah Smith, Krugman, Rowe, Plosser, and others just in the week prior to this post.

And this has caused a persistent itch of mine to clamor for scratching. Here goes.

The Lucas critique is fairly widely acknowledged to have at least exacerbated the trend toward insisting on microfoundations in macro theory, and thus the rise of New Keynesian Dynamic Stochastic General Equilibrium models. You know, representative agents showing rational expectations over generations, and all such things, reacting to policy changes. Which individual behaviors we can, more or less simply, just add up in order to understand the effects on the macro economy.

For those needing a brief review on "the" critique, Wikipedia is actually not bad, which I summarize. Lucas said:

"Given that the structure of an econometric model consists of optimal decision rules of economic agents, and that optimal decision rules vary systematically with changes in the structure of series relevant to the decision maker, it follows that any change in policy will systematically alter the structure of econometric models."

This is from his 1976 paper.

And the Wiki article summarizes the implications:

"The Lucas critique suggests that if we want to predict the effect of a policy experiment, we should model the "deep parameters" (relating to preferences, technology and resource constraints) that govern individual behavior. We can then predict what individuals will do, taking into account the change in policy, and then aggregate the individual decisions to calculate the macroeconomic effects of the policy change."

Thus, Bortis-style classical-Keynesianism was pretty much denuded: at best macro policy is effectively toothless, since that pesky agent will simply react to neutralize the policy actions;  and/or react so that the empirical regularities we were observing and making policy on will change. So we need to focus on micro and get that "right," the best we can do. The domination of Methodological Individualism on economic practice was on the rise.

I think Lucas got part of the diagnosis correct: individuals do react to macro policy changes but only indirectly. And he got most of it wrong. For the most part individual behaviors do not  directly change the  structure of the time series, but it is the change in the structure of the time series that changes individual behavior. Aggregate demand falls due to some shock - asset deflation, price shocks, war, pestilence, loss of income due to technology or offshoring. Producers then decrease output, and fire their workers.

This shock mechanism does induce individually optimizing behavior on the part of the business owner, given that what he optimizes is his profit function into which his production output enters.

For the newly unemployed person, since s/he no longer has a source of income, one can stretch and say that reducing consumption is individually optimizing at least of negative deviations from the budget. Of course this mechanism has it's own brutal zero lower bound - subsistence.  And does nothing to maximize utility.

Notice, no macro policy change is required here to start a recession or the recent depression; all we need is a sufficient shock to the system to start the negative feedback cycles rolling along.

We classical-Keynesian macroeconomists characterize these mechanisms as showing the fallacy of composition; the canonical principles of economics example is the paradox of thrift. You cannot use added-up individually optimizing behaviors to determine what is going to happen to the macro economy.

The reason is clear: emergent properties at the macro level have a life of their own. And its is these emergent properties like recessions and unemployment that directly affect the behavior of the economic person. I take here the strong version of emergent: a property or behavior at the aggregate level which cannot be observed or predicted at the individual level.

We do have methods that attempt to model this: the Keynesian aggregate expenditure model, but that is static. Dynamic macro econometric models, but those are difficult, and maybe it was because of these difficulties that the Lucas critique was so successful in attacking them.

I propose two things to restore the dominating importance of emergent macro properties on economic behavior. One is a recommitment to econometric modelling. Ever increasing data and increasingly better tools will continually improve modelling and forecasting results.

The other is a methodology that is vastly underused in economics, but widely used in various other sciences: network system analysis based on the mathematical theory of graphs. These methods lets us directly measure and model emergent dynamic behaviors from groups, like the individuals in an economy. No added up methodological individualism required; no agent-based model needed. Observe, model, and predict directly at the macro level.

While I believe empirical models, properly done, are fundamental to understanding and policy, network models provide us with a dynamic theory, emergent macro behaviors, that  support our correct Keynesian beliefs that it is the macro foundations of micro behavior that matter, not the other Lucasian way around.

Lucas in context, Keynes out of context

Krugman decided to try his hand at history of macroeconomic thought in one of his last posts. That's great, since history of thought is essential to understand how we got here. It's also bad, since Krugman is still very much a mainstream author, and misses the point of Keynes' contributions, and the limitations of neoclassical (or more properly, marginalist) approach. He suggests correctly that the New Classical (NC)/Real Business Cycle (RBC) project was a failure, but both the reasons for that and his interpretation of the Keynesian project are misguided.

The first proposition in Krugman's reassessment of the recent history of macroeconomics, is that Keynesian models were ad hoc, and assumed wage and price rigidity. The whole of chapter 19 of the General Theory (GT) is about the effects of price and wage flexibility, and how it does not produce full employment. It was with Franco Modigliani's PhD dissertation, done at the New School for Social Research under Jacob Marschak, that the sticky wage version of Keynesian theory that would dominate the neoclassical synthesis was concocted.

Keynes is actually quite explicit about the negative effects of wage reductions. He says (GT, ch.19-link above):

"A reduction of money-wages will somewhat reduce prices. It will, therefore, involve some redistribution of real income (a) from wage-earners to other factors entering into marginal prime cost whose remuneration has not been reduced, and (b) from entrepreneurs to rentiers to whom a certain income fixed in terms of money has been guaranteed.

What will be the effect of this redistribution on the propensity to consume for the community as a whole? The transfer from wage-earners to other factors is likely to diminish the propensity to consume. The effect of the transfer from entrepreneurs to rentiers is more open to doubt. But if rentiers represent on the whole the richer section of the community and those whose standard of life is least flexible, then the effect of this also will be unfavourable. What the net result will be on a balance of considerations, we can only guess. Probably it is more likely to be adverse than favourable."

Hence, the fix-wage version of Keynes' thought is the result of misconception, that suggests that if markets worked well, without imperfections, they would move to full employment. Unemployment is a disequilibrium, by definition a short run situation resulting from a rigidity.

The whole point of the neoclassical synthesis was to suggest that one could continue to teach that markets are efficient, and that supply determined the price and quantity of equilibrium in all markets including those of "factors of production" (i.e. the labor and capital markets), and as a result unemployment could only result  from rigidities in the labor market. Nothing revolutionary there, and in that case, as Keynes foresaw, people would think he was quite wrong or said nothing new.

By the way Krugman does not believe that rigid wages are behind our current lack of full employment (in his view it is the downward rigidity of the rate of interest; Keynes also did not believe in the liquidity trap as the cause of depressions), which makes it more difficult to understand why he defines Keynesians (Old and New) as pragmatic rigid price and wage modelers. You cannot blame then Laurence Kotlikoff for his confusion (here and Krugman's reply and here; Jamie Galbraith, also implicated, gives a better answer since he never said that Keynes is about wage rigidity; scroll down for Jamie's and Kotlikoff's back and forth).

Krugman's second point is that Friedman and Phelps in the 1960s were trying to provide microfoundations to wage and price rigidity. Actually, the microfoundations agenda had more to do with the theoretical development of theories for consumption (Modigliani, Friedman), investment (Eisner, Tobin) and money demand (Baumol, Tobin) behavior. The Phillips Curve (PC) debate and the Friedman-Phelps notion of a natural rate of unemployment is associated to the idea that there is a supply side constraint to the economy, and stimulating demand would ultimately have only effects on prices and not on quantities. The economy naturally moves to full employment, unless there are restrictions, and what is needed is to eliminate the restrictions not stimulate demand.

In other words, the monetarist approach of Friedman accepts the neoclassical synthesis notion that it is the rigidities that cause unemployment. It just proposes a different policy solution. By pointing out the existence of a natural rate of unemployment analogous to Wicksell's natural rate of interest (which Keynes' criticizes in the GT) Friedman was just emphasizing that if one believes in the neoclassical theory of value and there are no restrictions the system moves to full employment. In fact, Friedman's (1970) theoretical framework, an ISLM cum PC and natural rate model, is remarkably close to the neoclassical synthesis models.

In that sense, the Lucas Revolution and the subsequent move, after Kydland and Prescott's work, of most New Classicals , including Lucas, to the Real Business Cycles camp is a not a break with Friedman, and the New Keynesians (NK) that accept everything (including the natural rate) are part of the same tradition. The difference is that some emphasize the long run neoclassical principles and others the short run rigidities that demand policy action.

The fundamental problem of the neoclassical/marginalist approach, and the importance of Keynes analysis, can ONLY be properly understood in light of the 1960s capital debates (for a good reference go here). The point, for the purposes of our discussion here, is that if there is unemployment and real wages fall, neoclassical theory tells you that according to the principle of substitution, more labor is demanded (the cheap thing that is in excess supply) and less machines (capital) are used, since they are relatively more expensive. However, since labor (which is cheaper) is used in the machine sector too their price should fall too, and is not generally true that there is a tendency for the full utilization of "factors of production" according to their relative scarcities. Further, even if the substitution effects go in the right direction, and more labor is used, the income effect of lower real wages tends to be large and have a negative effect on demand (put simply, workers cannot buy stuff), which implies that less of all "factors of production" are used. In other words, there is no natural tendency to full utilization of labor or capital, and both the natural rate of unemployment and its evil twin the natural rate of interest do NOT exist.

So it is peculiar that Krugman thinks that "NK economics [is] useful, if only as a way to check my logic, although it’s not really clear if it’s any better than old-fashioned Keynesianism." What logic? New Keynesian models assume a natural rate, and that the economy (without rigidities) moves to full employment! The problem with the NC/RBC/Lucas' type of theory is not that it failed to predict the 1980s recession or that they think that most crises are caused by real shocks (although both propositions are obviously wrong), as Krugman seems to believe, but that they do maintain the fiction of an efficient market that clears (in their case too fast for Krugman's taste) and that produces a natural rate. If he wants to move in the right direction Krugman should follow Galbraith and announce that it is time to ditch the natural rate hypothesis.

PS: That means that progress in economics is not linear, and that one can and should learn from old and forgotten traditions (classical political economy did not assume full utilization of resources).

Lucas and Intelligent Design

A friend send me Lucas' Milliman Lecture at the University of Washington (Krugman commented here).  Lucas argues that this crisis was like the depression the result of a significant monetary contraction (he believes in Real Business Cycles, RBC, but only when it is convenient apparently), and suggests that Friedman and Schwartz Great Contraction interpretation of the Depression is correct.  For him recovery was slow (in spite of unemployment falling from almost 25% to around 9% from 1933 to 1936!) because the government intervened and demonized businessmen.  This is basically the same piece of ideological propaganda that Amity Shlaes in her book The Forgotten Man (terrible book, by the way) has been pushing around.

Certain things have to be said again and again because some people keep repeating lies until they become credible.  The New Deal did work (see here)!  Unemployment did fall significantly, and when they tried fiscal adjustment in 1937 (fall in expenses associated with pensions for WWI veterans, and new taxes associated to the Social Security Act) the economy contracted.  There is a reason why everybody in the profession became a Keynesian in the 1940s; because it worked, and the war economy was the ultimate proof of it.

In Lucas' view, recovery depends on the confidence of businessmen.  The question that people that believe in what Krugman aptly calls as the Confidence Fairy have to reply is why would businessmen invest if the economy is in the dumpster, and there is no demand for their goods, let alone to create new capacity by buying machines!  And should I also add that the evidence for investment is that it follows output?!  Logic and evidence have no relation with the sort of stuff Lucas believes, and he should not be taken seriously.

I'll quote again Marriner Eccles, the chairman of the Fed during the Depression, and a Republican from Utah, on the subject of confidence.  He said:

"Confidence itself is not a cause. It is the effect of things already in motion. (...) What passed as a 'lack of confidence' crisis was really nothing more than an investor's recognition of the fact that new plant facilities were not needed at the time."

And Eccles actually knew a thing or two about running real businesses.  Put clearly, lack of confidence is the result of lack of demand.  We need more stimulus, and confidence will return.

Lucas had a poisonous effect on the profession, leading it back to the dark ages of macroeconomics. He wants now to push the same sort of inane idiocy in the policy arena.  He suggests that the slow recovery results from Obama's European style social democratic programs!  Next thing he'll say that Obama is Kenyan.  Lucas and the New Classical Rational Expectations (and RBC) School are the intelligent design of economics.  They should have the same status in the scientific community.