Replacing the Phillips Curve: I showed you my macro model. Now show me your macro model.

Peter Dixon wrote a nice piece about my work …

To which I responded ….

Screen Shot 2019-04-18 at 10.13.54 AM.png

David Glasner weighs in with the view that the Phillips Curve is not a structural relationship.

Screen Shot 2019-04-18 at 9.45.31 AM.png

Here is my response.

Screen Shot 2019-04-18 at 9.53.22 AM.png
Screen Shot 2019-04-18 at 9.53.38 AM.png

And Stephen Williamson and Jorge Miranda-Pinto tell us that they have not been teaching the Phillips Curve as a structural equation for some time.

Screen Shot 2019-04-18 at 9.55.54 AM.png
Screen Shot 2019-04-18 at 9.56.02 AM.png

What are macroeconomists currently teaching their students? Time to teach a credible alternative to the NK Phillips Curve.

Here is me responding to David Glasner …

Screen Shot 2019-04-18 at 10.04.26 AM.png

In the following tweet, David responds using the language of the outdated IS-LM model.

Screen Shot 2019-04-18 at 10.02.08 AM.png
Screen Shot 2019-04-18 at 10.02.16 AM.png

As I explain below …, this is not a good answer.

Screen Shot 2019-04-18 at 10.07.57 AM.png

David sees IS-LM as a ‘convenience’ …

I want more. I want to see what’s under the hood. This is what’s under my hood … the IS-LM-NAC model and how to use it ….

Screen Shot 2019-04-18 at 10.09.59 AM.png
Screen Shot 2019-04-18 at 10.10.07 AM.png

There are many unemployment rates for any r*

Eric Lonergan has a new blog post in which he draws attention to the importance of the asset markets in business cycle dynamics. While there is much to like in that post, I find parts of Eric’s argument misleading. Here is Eric:


“This leads us to the how [stet] the equity market determines the ‘neutral policy rate’. I have argued in the past that we need to get away from the idea of some magic level of the interest rate that somehow brings inflation to 2% and the economy to full employment.”

Eric is even clearer in his tweets in which he asserts that "stock prices determine r*”. I disagree for the reason I outlined on page 195 of Prosperity for All. The stock price is a stock. r* is the ratio of a stock to a flow. If r* is 5% (for example) the (real) stock price could be 100 bushels of corn and earnings could be 5 bushels of corn or the stock price could be 200 bushels of corn and earnings could be 10 bushels of corn. Both cases would lead to a value for r* of 5%.

If there are 100 people in the economy and it takes one person to harvest a bushel of corn, the first case would correspond to an unemployment rate of 5% and the second case would correspond to an unemployment rate of 10%.

In a second passage, Eric points out that recessions are typically preceded by stock market falls.

“Stock markets are a measure of recession risk. They are not predictors of recessions, as such. Paul Samuelson famously quipped that the stock market has predicted seven of the last three recessions – or words to that effect. But the joke is only partly insightful. Yes, there is excess volatility in stock prices for a host of reasons, but the probability of recession fluctuates, so stock prices should fluctuate with these probabilities. In that sense, the stock market should ‘predict’ more recessions than actually occur.”

Here Eric and I agree. But I would go further. Persistent drops in the stock market are not simply indicators of a future recession: they are causes of a future recession. This is demonstrably true in the sense of Granger Causality, as a I show here. And the word ‘persistent’ is important in this statement. A one-day crash that comes back a week later has no impact on the unemployment rate. A one day crash in the stock market that persists for three months does have an impact.

To get beyond Granger Causality, one needs a theory of how stock market crashes, triggered by a loss of confidence, so called animal spirits, can generate a causal chain that increases unemployment. I have developed such a theory here. This theory explains why ANY unemployment rate can be consistent with an equilibrium in which no market participant has an incentive to change his or her behavior. And it explains why there is no correspondence between r*, the so called natural rate of interest, and u*, the socially optimal rate of unemployment.

Why deficits are sustainable and inflation has a life of its own

Screenshot 2019-01-14 16.16.53.png

My new working paper “The Fiscal Theory of the Price Level in Overlapping Generations Models” is now available here. The paper, joint with Pawel Zabczyk of the IMF, is also available as CEPR Discussion Paper 13432 and as NBER Working Paper 23445. Here is a teaser from the abstract

“We demonstrate that the Fiscal Theory of the Price Level (FTPL) cannot be used to determine the price level uniquely in the overlapping generations (OLG) model. We provide two examples of OLG models, one with 3-period lives and one with 62-period lives. Both examples are calibrated to an income profile chosen to match the life-cycle earnings process in U.S. data estimated by Guvenen et al. (2015). In both examples, there exist multiple steady-state equilibria. Our findings challenge established views about what constitutes a good combination of fiscal and monetary policies. As long as the primary deficit or the primary surplus is not too large, the fiscal authority can conduct policies that are unresponsive to endogenous changes in the level of its outstanding debt. Monetary and fiscal policy can both be active at the same time.”

Given the recent publicity for deficit spending by Olivier Blanchard writing on his PIIE blog, or the interview with Stephanie Kelton in Barrons, we think our paper is timely. We demonstrate that sensible models with realistic population demographics support some, but not all, of the arguments of Blanchard and Kelton. For example, although a large value for government debt as a fraction of GDP is not necessarily a problem, large values of the deficit probably are. In our calibrated model, (in work in progress that is not reported in the paper) we were unable to generate sustainable deficits much larger than 3% of GDP. Anything larger than that leads to an Argentinian style hyperinflation.

It also matter, a lot, who holds the debt. Large values of domestically held debt are simply a redistribution from future to current taxpayers. Large values of foreign held debt however represent a claim on the domestic economy by foreigners. Foreign held debt is much less benign than domestic debt.

Finally, our work sheds light on the current difficulty faced by western central banks who appear to be unable to hit their inflation targets. Milton Friedman argued that inflation is caused by excessive money creation. More recently, some economists have argued that inflation is a fiscal phenomenon; hence the title of this post which refers to a new theory, the Fiscal Theory of the Price Level. In contrast to both leading contenders, we show that the price level may fail to be anchored by economic fundamentals and, within certain bounds, the average price of commodities may wander aimlessly driven by the self-fulfilling beliefs of market participants.

This is the second paper of a series. The first, “The Household Fallacy” was published last year in Economics Letters. Sty tuned for further installments.

Social Progress is not an Illusion

Screenshot 2019-01-12 12.29.48.png

I recently came across this critical review of Steven Pinker’s book, Enlightenment Now: The Case for Reason, Science, Humanism, and Progress, by Jeremy Lent in the online magazine, Open Democracy. Jeremy makes some good points, but then proceeds dramatically to overstate his case by painting a monothlithic concept of ‘free market economics’ as the enemy of progressives everywhere.

There is no such thing as free market economics. As I point out in Prosperity for All every market economy operates under a set of institutional constraints that determine the rules of the game. While Pinker may also have overstated his argument in places, it is hard to argue with the progress made by free trade and property rights in catapulting 1.5 billion Chinese out of poverty. The absolute income gains of Chinese peasants may not be as large as those of fortune 500 billionaires, but they are very real. And they were delivered by a move from central planning to a free market economy, and most importantly, by a recognition of the importance of property rights.

In his review, Jeremy downplays the gains of free markets. Instead, he brings us a vision of the ‘noble savage’ living by fishing and growing staples on a small patch of land which is then appropriated by mega corporations. Most of us would rather live as the median person in the wealth distribution in a modern industrial society than as a peasant farmer in a preindustrial utopia that has never existed outside of the minds of a few idealistic fellow travelers.

Capitalism does not deliver equality of outcomes. If our current institutional arrangements lead to a socially unacceptable degree of inequality, the right response is to change the institutional structure within which markets operate. It is not to give up on market exchange. And if there is a social consensus that the benefits of higher living standards are endangering the planet, the solution is to adapt market institutions not to destroy them.

In the twentieth century, inheritance taxes on large estates made a dent on the wealth distribution and to a seismic change in social relations. In the twenty-first century, Jeremy Lent rightly points out that social norms have evolved, and are evolving, rapidly. I for one, believe that some degree of inequality of outcomes is both inevitable and desirable as the cost of individual freedom. The ‘right’ degree of inequality is a question to be solved through open debate and institutional reform, not through a western replay of the Cultural Revolution.

Don't Trust the Markets

In a week when the Vix is at a seven-year high and the markets are back to the trading range of the summer of 2017, now seems like a good time to revisit the theme of market efficiency. Here is a link to the pre-publication version of an academic paper I published this year in the Review of Economic Dynamics.


The paper is a formal model of an argument I’ve been making for a while.  Although it’s not possible for the average punter to make a buck in the financial markets we should definitely NOT trust the financial markets to do a good job allocating capital intertemporally. As Richard Thaler explained in his review of Justin Fox’s book The Myth of the Rational Marketthe efficient markets hypothesis (EMH) has two components. 

The first, ‘no free lunch’ asserts that unless you have inside information, it is impossible to outperform the market except through dumb luck. That is almost certainly correct, although even that part of the EMH is disputed by some.

The second, ‘the price is right’, asserts that the financial markets allocate capital efficiently over time. Efficiently, here, means that there is no intervention by government that could make us all better off. That, despite the protestations of radical free-marketeers, is almost certainly wrong.  My paper explains why.

The financial markets facilitate trade with people not yet born. If you buy a stock and sell it twenty years later, there is a good chance the buyer wasn’t alive when you made the purchase. When you buy the stock for the long-run, you are betting that the buyer, twenty years from now, will pay more than you did. And the buyer is making the same forecast about the whims of some other buyer in the yet more distant future. This never-ending chain of market trades leads to the possibility that self-fulfilling prophecies lead to inefficient cycles of booms and crashes.

For the cognoscenti, here is the abstract from my paper

This paper constructs a general equilibrium model where asset price fluctuations are caused by random shocks to beliefs about the future price level that reallocate consumption across generations. In this model, asset prices are volatile, and price-earnings ratios are persistent, even though there is no fundamental uncertainty and financial markets are sequentially complete. I show that the model can explain a substantial risk premium while generating smooth time series for consumption. In my model, asset price fluctuations are Pareto inefficient and there is a role for treasury or central bank intervention to stabilize asset price volatility.

Have fun trading everyone and I wish you all a very  happy 2019.