8/19/09 12:49 PMTyler Cowen on the State of Macroeconomics

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August 09, 2009

Tyler Cowen on the State of Macroeconomics

What Is This "We," Kemosabe?

He has smart things to say--like that, contra Lucas's claim, it was not a victory for

the Efficient Market Hypothesis that economists (except for Mussa, Krugman,

Baker, and their posse) did not worry about the housing bubble and the size of the

lower tail of asset price changes:

Lucas roundtable: Some successes, some failures: Let me focus on some areas

where I disagree with Mr Lucas.... I think he is too quick to cite the Efficient

Markets Hypothesis (EMH) to dismiss criticism that economists should have

predicted the collapse. To be sure, Lucas is correct that we should not expect

economists to predict the timing of changes in security markets prices. That

said, I do still think that economists—myself included—missed the boat in a

fundamental way. Too many economists thought that a collapse of the recent

magnitude was unthinkable, especially since financial institution CEOs generally

had their own money on the line. To put the point into EMH lingo, we

miscalculated systematic risk very badly. We underestimated financial fragility

and we underestimated the extent to which common expectational errors,

across many entrepreneurs and indeed many nations, were possible. Citing

EMH does not in my view excuse this error or account for it.

Second, one can believe in EMH and still think it is possible to identify bubbles

in the housing market ex ante. It is difficult to sell houses short and so the

bubble can last for some time, even if it has been identified by informed

observers. One group of economists, including Ben Bernanke, significantly

underestimated the potential for large and systemic risk in the housing market.

This was a simple, flat out error. We don’t have to toss out modern

macroeconomics, but we do need to ask why it happened.

8/19/09 12:49 PMTyler Cowen on the State of Macroeconomics

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macroeconomics, but we do need to ask why it happened.

Third, Mr Bernanke and many others, again including myself, failed to

appreciate how much the Lehman failure would cause some credit flows to shut

down. It was surprising to see the interbank repo market collapsing so radically,

as has been analysed since by Gary Gorton. There is something fundamental

about financial intermediation that we did not understand and probably still do

not understand. Why should those markets have dried up so thoroughly and so

quickly? Why wasn’t a price adjustment sufficient to restore equilibrium? Why

is the continued operation of these markets so important for the real economy?

Fourth, the recent debates over fiscal policy and stimulus have not enhanced

my confidence in macroeconomics. Analytic conclusions in this area seem to

line up too tightly with the political views of the researchers. If we can’t

understand fiscal policy, I suggest something broader is amiss...

I do however, find myself puzzled by Tyler's last paragraph.

Who is this "we" he speaks of?

Tyler Cowen understands fiscal policy very well. If you ask him how it is that

expansionary fiscal policy can increase the flow of nominal demand, he can identify

all four parts of the elephant blindfolded:

1. In a Quantity Theory of Money System: If a collapse in market risk tolerance

leads to a sharp fall in the short-term nominal interest rate on Treasury

securities, that will diminish the opportunity cost of holding money balances

and so reduce monetary velocity and thus the flow of nominal demand.

Expansionary fiscal policy increases the stock of government bonds outstanding,

lowers their price by supply and demand, and thus raises the opportunity cost

of holding money balances and puts upward pressure on velocity...

2. In a Neo-Wicksellian Flow-of-Funds System: If a collapse in market risk

tolerance pushes the natural rate of interest negative--to a place where the

market interest rate cannot go--and so creates an deflationary gap where

planned investment is less than actual national net saving, government deficits-

-dissaving--that reduce national net saving eliminate this deflationary gap

between investment and saving, and relieve what would otherwise be downward

pressure on the flow of nominal spending...

3. In a Keynesian Income-Expenditure System: If a collapse in market risk

tolerance leads to a sharp rise in inventories that causes firms to start firing

people, boosting government spending without boosting taxes soaks up those

excess inventories, and then there is no signal to private companies adjusting

quantities rather than prices that they should fire more workers, which would

lower incomes, which would lower consumption spending, which sets off the

multiplier process...

4. In a Credit-Channel System: If a collapse in banking-sector capitalization leads

to an intensification of moral hazard and adverse selection problems in capital

markets, private financial intermediaries will no longer be able to strike

8/19/09 12:49 PMTyler Cowen on the State of Macroeconomics

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markets, private financial intermediaries will no longer be able to strike

contracts to intermediate flows between saver sources and users of funds. But

the government--as long as the government's debt remains the safe asset in the

economy, that is--is not subject to these moral hazard and adverse selection

problems, and expansionary fiscal policy is a way for the government to serve as

financial intermediary of last resort...

(My standard references for these four ways of thinking about fiscal policy are Hicks

(1937), Krugman (2009) (quoting Jan Hatzius: where is a longer version?), Keynes

(1936), and Gertler (2009). Note that these are not, in any sense, contradictory or

inconsistent--just different ways of touching the elephant.)

I agree with Tyler that there is something very wrong with those who "cannot

understand fiscal policy." I just don't understand why he puts himself in the "we"

there--I wish his language were less Aesopian.

And when Tyler says that "analytic conclusions in [macroeconomics] seem to line up

too tightly with the political views [of researchers]," I think that is wrong too.

Republicans like Glenn Hubbard, Greg Mankiw, Mark Zandi, and Ben Bernanke

have no problem advocating fiscal expansions as a tool for fighting recessions (tax

cut-heavy fiscal expansions, admittedly). Democrats like Alice Rivlin have no

problem saying that it is time to stop thinking deficits are an aid to fighting

recession and start worrying again about the long-run fiscal sustainability of the

American government. Republicans like Kevin Murphy have no problem saying that

even though fiscal policy would be somewhat effective its costs would outweigh its

benefits. Democrats like me have no trouble saying that banking-sector policy

should be carried out not through the U.S. Treasury but through a bipartisan

technocratic institution like the RTC or the RFC.

The divide that worries me isn't sensible Democrat-sensible Republican. The divide

that worries me is between economists who understand that the nominal money

stock is not a sufficient statistic for the flow of nominal demand--especially when

interest rates on short-term Treasuries are very low--and those who don't know

enough to have figured that out, and who think that the nominal money stock is a

sufficient statistic for the flow of nominal demand--even when interest rates on

short-term Treasuries are very low.

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2 more recommended posts »

Brad DeLong on August 09, 2009 at 10:08 AM in Economics, Economics: Federal

Reserve, Economics: Finance, Economics: Fiscal Policy, Economics: Macro |

Permalink

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Libertarians in the Desert...(this site)

Sketch of a Talk on the History of Macroeconomic Thought since 1960...(this

site)

8/19/09 12:49 PMTyler Cowen on the State of Macroeconomics

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Take another look at #2, neo-Wickselian -- I think you got a phrase backwards. You have

deficits as a cure for inflation. Or else something is subtler than it seems.

Posted by: Michael | August 09, 2009 at 10:53 AM

This is OK as far as it goes, but I'm not sure "error" is a sufficiently descriptive term to capture

the complete failure of the profession to recognize that our top banks are engaged in

fundamentally crooked and parasitic enterprises.

The profession completely failed to recognize that the people who were supposed to be

managing and distributing risk to those better able to bear it were instead multiplying risk in

order to pocket the bezzle, and then distributing the risk to those who could not recognize it.

The profession completely failed to recognize that the people who were supposed to be drawing

substantial compensation for managing the credit channels had given that up and were just

plain rent-seeking.

In other words, the profession completely failed to recognize that it matters what kind of

institutions we have.

I see no indication that this has changed, especially within the Obama administration.

Posted by: albrt | August 09, 2009 at 11:41 AM

Important elements of the economy prepare for a deflation in secret. Then approach the central

bank en mass for a bail out after the deflation is underway.

In other words, financial elements are intent on finding the moral hazard in any centralized

scheme designed by government economists. The more central planning, the more moral

hazard.

We can describe the process in mathematics ex post, but there will be no ex ante discovery, the

process works by preventing ex ante discovery.

Posted by: Mattyoung | August 09, 2009 at 12:12 PM

"If a collapse in market risk tolerance..."

But Brad, what causes these sudden, generalized collapses of risk tolerance?

Is it sun spots or some sort of cosmic radiation spike?

Maybe wobbles in the Earth's magnetic field are to blame?

Or perhaps there is a more spiritual explanation?

Posted by: Drewfuss | August 11, 2009 at 06:40 AM

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8/19/09 12:49 PMTyler Cowen on the State of Macroeconomics

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Me: Economists:

Paul

Krugman

Mark

Thoma

Cowen and

Tabarrok

Chinn and

Hamilton

Brad Setser

Juicebox

Mafia:

Ezra Klein

Matthew

Yglesias

Spencer

Ackerman

Dana

Goldstein

Dan

Froomkin

Moral

Philosophers:

Hilzoy and

Friends

Crooked

Timber of

Humanity

Mark

Kleiman and

Friends

Eric

Rauchway

and Friends

John Holbo

and Friends

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